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Goodwill and Goodwill Impairment in Value Investing

January 09, 2012 | About:
Warren Buffett has said that accounting was the language of the business, and in order to understand how a business is operating, investors should understand accounting and its flaws so that they can give proper judgment on the real performance of certain businesses. The number representation is just one thing, but what is really going on behind the numbers, is very crucial.

In financial statements, there are some items which reflect the real economic activity that are very useful for investors to judge the intrinsic value of a business. There are also other items which are just accounting figures. They just happen to be the booking of certain economic transactions but are not helpful for investors to focus on to determine the true business value. One accounting item which has been talked and discussed quite often is “goodwill,” and actually in one of my posts, I hwrote about Warren Buffett's discussion on the goodwill matter.

Goodwill, by definition, is the accounting concept meaning the value of an entity over and above the fair value of its assets. When a company acquired the target company for the price higher than the fair value of identifiable net assets of the target, the difference between the purchase price and the total fair value of target’s net assets is booked into the item “goodwill” in the acquirer’s balance sheet. Goodwill sometimes can be negative, when the net assets at the date of acquisition, fairly valued, are more than the buying price. For example, the company A got $5 million in its assets (assuming it has no debts) including lands, equipments), and it is acquired for $12 million by company B. So in the eyes of company B, the intrinsic value of company A would be worth $12 million at the date of acquisition, the $7 million more might be due to the brand name, customer database, intellectual property, etc. So after acquiring company A, company B’s asset would have $7 million recorded in the separate item named “goodwill.”

Before, this goodwill item was amortized over the life chosen by the management, maximum of 40 years, so normally the managers often chose 40 years to amortized overtime. But now, it will not be amortized, but be frequently tested for “impairment.” If the management decided that the goodwill is actually impaired, goodwill item would be written off the book, flow to income statement and hurt net earnings. However, as it does not involve in the inflow or outflow of the cash, so the cash flow item is not affected by the goodwill write-off. For different accounting standards, U.S. GAAP and IFRS, each would be different in terms of revaluation after writing off, but I would not go into the details here in this article. The impairment relies on the subjectivity of the management, so that’s the “grey area” that the management could manipulate to boost earnings in the short-term period. So is goodwill the real asset of the company? And how should investors treat goodwill?

Benjamin Graham had written that intangibles assets should not be taken into account when calculating book value, in this sense, book value per share would be equal as net tangible assets per share as opposed to net assets per share. He considered goodwill like water, not representing the real assets of the company. He wrote in his writing on the importance of tangible values: “The striking fact is not so much the large quantities of goodwill concealed in the plant account, but the extent to which most companies have succeeded in replacing this original water by real assets, and in creating a foundation of solid value for their (shares). The public has long had a general idea as to which companies were overcapitalized and which have been most successful in remedying this defect. But the question of tangible value has now assumed far greater significance than ever before because of the gradual progress of many of these issues into the investment class.”

And Michael Price, in the introduction to Benjamin Graham’s book, “The interpretation of Financial Statements”, he describes his first experience with "intangibles," the broader definition for goodwill. When he was examining at a small brewery, F&M Schaefer Brewing Company, he looked at its balance sheet and saw $40 million in net worth and $40 million in intangibles, and it was trading well below its net worth.

He recommended buying but Max Heine, his boss at that time, asked him to look closer. He looked again in the notes but couldn’t find the explanation of where the intangibles figure came from. He called up the treasurer and said, ”I am looking at your balance sheet. Tell me, what does $40 million of intangibles relate to?” The treasurer replied, “Don’t you know our jingle, Schaefer is one beer to have when you are having more than one.” Michael Price thought it was way overstated, increased book value and showed higher earnings than were warranted in 1975. The purpose was to keep the stock price higher than it otherwise should have been. So he didn’t buy it.

Last but not least, Benjamin Graham discussed in the book mentioned above on the good-will write down, and I think investors should really listen to it. He wrote: “This writing down of good-will does not mean that it is actually worth less than before, but only that the management has decided to be more conservative in its accounting policy. This point illustrates one of the many contradictions in corporate accounting. In most cases the writing off of good-will takes place after the company’s position has improved. But this means that the good-will is in fact considerably more valuable than it was at the beginning.”

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


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Comments

ramands123
Ramands123 - 2 years ago


A suggestion for gurufocus, As said in the artical above "Warren Buffett has said that accounting was the language of the business, and in order to understand how a business is operating".

I think it might be very helpfull for readers if gurufocus can have a dedicated section for accounting related topics broken down by skill level - starters , to intermediate to advance accounting concepts.
ken_hoang
Ken_hoang - 2 years ago
Hi Ramands: It is the great idea. Understanding accounting and the development of accounting overtime will help investors extremely lots in terms of understanding how the business is conducting. Investors can look back at the past to see the changes in accounting assumptions and to somehow determine the quality of the management via that, as well as detecting the potential frauds in the future.

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