A Gesture of Goodwill?

September 23, 2016

A Gesture of Goodwill?

  • There is a difference between accounting and economic goodwill.
  • Facebook’s $18 billion goodwill acquisition of WhatsApp looks a lot like AOL Time Warner’s goodwill of $128 billion.
  • Economic goodwill not on balance sheets is what to look for. Unfortunately, you won’t see it anywhere.

Introduction

Accounting is an essential part of analyzing a company as different accounting regulations and principles bring about totally different analysis results.

In today’s article, I’m going to give you a small piece of insight on how I do research, how it differs from the usual screening processes that most use, and why it is important. I won’t elaborate on all the possible inconsistencies instance-by-instance as that analysis is better left to books on accounting. Instead, we will discuss one small line item on the balance sheet, goodwill, and how it can severely skew one’s perception of a company.

What Is Goodwill?

When company A takes over company B, goodwill is defined as the difference between what company A paid for company B and the fair value of the assets of the company taken over. An example that we will use throughout the article is Facebook’s (NASDAQ: FB) 2014 WhatsApp acquisition.

The purchase consideration for WhatsApp was $17.1 billion. As WhatsApp didn’t have any tangible asset value, the $17.1 billion increased FB’s intangible assets and goodwill accounts. $2 billion was the estimated value of the acquired users, $0.44 billion was the value of trade names, $0.28 was the value of the acquired technology and $15.3 billion was the estimated value of the non-identifiable assets.

figure-1-fb-goodwill
Figure 1: FB’s 2014 acquisitions with no tangible value. Source: FB.

When your spouse comes home and tells you that she or he bought some expensive new purse or gadget you can express your anger or disappointment. But imagine being a shareholder of a company that spent $17 billion on something that is neither tangible nor profitable.

We aren’t going to discuss whether the WhatsApp acquisition was justified and increased shareholder value, but what we are going to discuss is the effect it has had on FB’s balance sheet.

What Does Goodwill Measure & How Should It Be Approached?

Goodwill is there to show that there is a difference between the accounting value and the perceived value of a company. Accounting values are measured at historical cost and therefore doesn’t include assets that are wrongly valued, the growth potential that an asset can bring and, in some cases, the pure overpayment of the acquirer.

One clear example of overpayment is the 2000 AOL purchase of Time Warner for $147 billion. Of the $147 billion, a staggering $128 billion was added to the new company’s balance sheet as goodwill. In 2002, AOL Time Warner was busy writing off goodwill and the headline below was the result.

figure-2-aol-impairment
Figure 2: AOL Time Warner goodwill impairment. Source: Wall Street Journal.

The fact is that goodwill can easily change over time. Companies are required to test their goodwill for impairment yearly if they believe its fair value is below the value on the books. As only after the investment community forces companies to impair goodwill due to low sales or a bear market, it can take a lot of time to see if there is real value behind goodwill that doesn’t produce a heathy stream of cash.

In the meantime, what goodwill skews are the ratios which might make you believe a company is better than it really is. By taking a look at FB’s balance sheet, we can calculate a few investment ratios and compare them with or without the goodwill.

figure-3-fb-balance-sheet
Figure 3: FB’s balance sheet. Source: FB.

A clear example is the calculation of book value per share. FB’s book value per share in 2015 was $14.62 according to Morningstar. But if we calculate tangible book value, thus remove intangibles and goodwill, we get a value of $8.04, or on 55% of the initial value.

So when you do a market screen to look for companies by book value or debt to assets, those companies that have a lot of goodwill will show up more in your searches. Also, high goodwill increases the perception of the safety margin when investing as the book value in the form of goodwill that further translates into equity gives better ratios, and thus a perception of less risk.

Unfortunately, as in the AOL Time Warner example, goodwill can quickly erode as impairments become inevitable, especially if there is no economic benefit coming from the assets (think of revenue and cash flows).

Economic & Accounting Goodwill

But not all is that negative. There is also economic goodwill that isn’t shown in any financial statement and is essential for an investment. In his 1983 letter to shareholders, Warren Buffett took the time to explain the difference between the accounting goodwill that we defined above, and economic goodwill which he defined as “a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel” for one of Berkshire’s subsidiaries, See’s Candy.

As See’s Candy was bought for $25 million in 1972, that was its book value (plus the additional $40 million invested) on Berkshire’s balance sheet, but since then it has generated $1.9 billion in pre-tax earnings and therefore its value is much higher than the value shown on Berkshire’s balance sheet. On top of that, the economic moat that enabled such earnings is also not shown on any financial statement and also doesn’t come out in ratios or on screens.

Conclusion

The main point is that goodwill can be misleading. On one hand, accounting goodwill can make a company appear better than it really is, but on the other a company can have minimal assets on its balance sheet and have huge levels of economic goodwill.

This economic goodwill translates into higher earnings over time. However, by doing quantitative screens, you will miss such a business. Therefore, the more stones you turn and the more balance sheets you question, the more low risk high returns investments you will find.

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