Proper treatment of Goodwill in valuation

[Guest fedcep]

Hello everyone,

 

I wanted to hear your thoughts on Goodwill on the balance sheet and how it impacts your valuation. Personally, I automatically exclude GW on the premise that if a firm truly has a competitive advantage, it will show in their FCFs (unless very specific cases, such as an acquisition of a biotech firm with a valuable upcoming product pipeline). In my experience, GW is an artificial GAAP artifact and usually the result of serial-acquirer sprees by management. And, even if it isn't, I feel like I would be punishing a firm with a great business model that has made acquisitions if I included GW when evaluating their profitability.

 

I'm having trouble understanding what the upside of including GW in book value appraisals is. You can always value brands independently and add them later in the very rare occasion that the firm's brands are indeed valuable (SHLD comes to mind). Adding to that point, suppose a firm bought a brand, for which it recorded GW. You will not have future capex associated with that "asset". Sure, you can argue that advertising expense is a form of capex for a brand. But that expense is already built into CFO.

 

I know that some value investors are against excluding GW, so I'm looking forward to hearing your perspective and see what it is that I'm missing.

 

Thanks

[Guest fedcep]

As an addendum, WEB addresses economic (not GAAP) Goodwill in the appendix of his 1983 letter. But back then GW rules implied regular amortization on the income statement, which is what I think he's referring to here:

 

1. In analysis of operating results – that is, in evaluating the underlying economics of a business unit – amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operation’s economic Goodwill.

[scorpioncapital]

Goodwill is an attempt to represent equity valuation on the balance sheet as opposed to the share market. It's the difference between cost and market value. It represents the essence of investing really - you can see all the smart or bone-headed deals a company has ever made in the goodwill. Conversely, you can see how they mark up or down their organic business based on what they think the cash-flows are. It's a great way to see the insider's opinion about business value as opposed to the market or your own.

[Liberty]

Goodwill is an attempt to represent equity valuation on the balance sheet as opposed to the share market. It's the difference between cost and market value. It represents the essence of investing really - you can see all the smart or bone-headed deals a company has ever made in the goodwill. Conversely, you can see how they mark up or down their organic business based on what they think the cash-flows are. It's a great way to see the insider's opinion about business value as opposed to the market or your own.

 

It depends on the industry, though.. Lots of software companies will be sold higher than book value because so much of their value is in intangibles, so you'll see more goodwill on the balance sheet of companies that acquire software companies than, say, on the balance sheet of companies that acquire financials.

 

edit: to be clear, I wouldn't evaluate a software company on book value anyway, so it doesn't change much, but this should still be kept in mind. Some business by definition will be acquired above book if they are good, it doesn't mean the acquirer has overpaid.

[Guest rimm_never_sleeps]

evaluating goodwill takes qualitative skill. for example, the goodwill on brk and rimm balance sheet may be quite different from a qualitative perspective. my understanding is buffett ignores it and tries to find out what a company earns on it's operating assets, pre tax.

[Guest fedcep]

Thanks for the replies. That's what I prefer doing -- just let the flows do the talking and then try to assess their sustainability. Mind you, I don't think that's what WEB was referring to on that quote, but rather amortization of GW on the income statement -- this was 1983 so it was still in place on GAAP.

 

Agreed on all counts although I'm admittedly skeptical about the value of including book GW in valuation. I agree that high GW tends to be more of a red flag than something positive. Scorpion, when you say GW is a good way to learn an insider's opinion, are you referring strictly to the number on the books and maybe some comments on the MD&A, or do you have something more specific in mind? If so, I'd love to hear an example.

 

Finally, I apologize in advance for nit-picking, just testing that my grounds are correct: as far as I know, GW can only be written down, not up. So I assume you were referring to purchases?

 

Thanks again, everyone.

[racemize]

GW can drastically underestimate the value of companies, e.g., see Geico for BRK where they bought the first half at a cheap value and then later bought the remaining half for a lot more--had the first half been on the books with its GW, the GW portion would not match the value paid for the second half at the later time.  On the other hand, GW for poor acquisitions is worthless.  I only give GW value for companies where the acquisitions are good (essentially only BRK at this point). 

 

I usually also evaluate on FCF and ignore book, as you are saying, which is simpler anyhow.  It is nice to have multiple models for valuation though, as you can pick the most conservative one for determining whether to buy.

[JEast]

Most of the time goodwill is worth squat - delete it in your evaluations.  However, sometimes and if the company has a competitive advantage and/or moat, goodwill may be worth more such as 2-3X of SG&A.  This is just a rule of thumb from a deep value G&D investor. 

 

There are professionals on this board that may comment on the cash flow perspective for goodwill that will differ.

 

 

Cheers

JEast

[infinitee00]

You can always value brands independently and add them later in the very rare occasion that the firm's brands are indeed valuable (SHLD comes to mind). Adding to that point, suppose a firm bought a brand, for which it recorded GW.

 

I generally don't like to value brands separately as it is too subjective an exercise for me (similar to goodwill), not to mention, some valuable brands can and do lose value permanently in a very short period of time. The strength of a brand is generally reflected in it's gross and operating margins compared to other companies in the same industry. So, for me, to put a value on the brand would be somewhat similar to double-counting.

 

 

[mpauls]

Many ways to handle it. 

 

Goodwill ultimately enters into the value equation in much the same way as the value of good management.  You don't add an additional component of value to your appraisal to account for good management.  Goodwill, like good management, is directly reflected in the value of a business (properly calculated.)  Oh, and I'm talking about economic goodwill not accounting goodwill.

[mpauls]

Just like advertising spend, you would be wise to use goodwill as a test of the competence of management in terms of their use of owner funds.  Are the acquisitions adding, maintaining or diminishing incremental value?

 

[Guest rimm_never_sleeps]

You can always value brands independently and add them later in the very rare occasion that the firm's brands are indeed valuable (SHLD comes to mind). Adding to that point, suppose a firm bought a brand, for which it recorded GW.

 

I generally don't like to value brands separately as it is too subjective an exercise for me (similar to goodwill), not to mention, some valuable brands can and do lose value permanently in a very short period of time. The strength of a brand is generally reflected in it's gross and operating margins compared to other companies in the same industry. So, for me, to put a value on the brand would be somewhat similar to double-counting.

 

yeah how do you value brands? I remember people were saying nokia has one of the most valuable brands in the world right before it fell off a cliff.

[kevin4u2]

Goodwill should play no part in a valuation exercise.  Like Buffett says, calculate the return on unlevered tangible assets to determine how good the business is. 

 

Goodwill or no goodwill I just look at the INVESTOR RETURN on CAPITAL.  That is, at the current price what is a reasonable return I can expect to earn on my capital. 

 

Goodwill or no goodwill, if you buy a stock for over book value you are ascribing INVESTOR goodwill to the business.  It is no different than one business buying another for over book value.  It is likely the business is earning high returns on equity and capital if you are willing to pay such an amount. 

 

I own a couple stocks that have outstanding businesses that have grown organically (hence no goodwill on the balance sheet).  I have always purchased at above book value because the economic goodwill is definitely there (very high returns on equity and capital). 

 

One test I often ask myself to see if a company has a moat or competitive advantage is "Do the customers advertise for them?"  Are the customers devoutely loyal?  Is the company logo displayed on vehicles, jackets, hats, etc by the customers.    Often when this is the case the company has an entrenched competitive advantage, it is earning high returns on capital (as a result), and the company likely has economic goodwill. 

[Packer16]

Although goodwill is probably not directly useful in valuation there are alot of related disclosure that provides insight into managment's expectation of the business.  For example, in the radio/TV industry the firms have to perform an annual impairment test of their intangible assets (or more often if an impairment event occurs).  This test includes valuing each cluster with the key assumptions outlined in the footnotes. 

 

In addition, for aquisitions the goodwill acquired is tested for impairment in a similar way on a yearly basis.  If there is an impairment, then the acquisition did not perform as planned.  In addition, if there is a total disaster then the acquired intangibles can also be impaired. 

 

The typical way a tradename is valued is by discountuing a 3rd party royalty rate.  In some industries (like apparel and consumer products) licensing is quite common so royalty rates are available.

 

Packer

[Guest fedcep]

Thanks everyone for the replies. Much appreciated.

[SharperDingaan]

Keep in mind what 'Goodwill' is, how it shows up under various accounting standards, & that the logic also shows up under a different name in other BS lines.

 

Impairment testing is a IFRS accounting requirement. Other accounting standards do not necessarily impose the same rigor. Capitalization of start-up & marketing costs is a very close cousin.

 

Does that market research really have a measurable revenue stream stemming directly from it? If the whole of that deferred sales capitalization is valid ... why are so certain a portion of the underlying business will not simply walk away?