"Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill." — Warren Buffett
During my teenage years I once worked for an elderly restaurateur who frequently lamented about the stressful nature involved in running his rib shack. His dream was to close down the rib shack and purchase a hot dog cart, thus eliminating the constant pressure of interpersonal conflicts among his employees as well as reducing his dependence upon his frequently unreliable employees. I wonder if Warren Buffett ever pines about such matters and secretly longs to return to the days when he delivered newspapers as a youth — I doubt it, but he is still buying up newspapers.
The hero of my column is a fictitious first-generation America named Horatio Gulash who achieves the American dream by purchasing and operating a wildly successful hot dog cart business. The point of this column is to illustrate seemingly complex financial and accounting concepts through the eyes of a simple businessman. In the process I hope to make the mundane more interesting and help readers understand basic concepts which only appear to be complex when they are cloaked in financial jargon.
Today's adventure involves Horatio's discovery of an extraordinary business and deals with a rudimentary accounting concept known as goodwill which appears on the balance sheets of many publicly traded companies.
Old World Franks
Horatio Gulash settled down in St. Louis shortly after immigrating to the U.S. from Budapest, Hungary. Horatio's relatives helped him to secure a job in a downtown restaurant which draws large crowds during the baseball season. Initially, Horatio is hired to clean up and wash dishes during Cardinal games, but soon he secures a full-time position due to his impeccable work ethic.
Down the street from the restaurant an elderly man operates a hot dog stand named "Old World Franks". The business is open during the lunch hour on weekdays and three hours prior to the first pitch of St. Louis Cardinal baseball games. Horatio notices when the stand is open it generally draws steady business, particularly prior to Cardinal games when the lines are excessively long. In fact, the stand generally sells out of hot dogs well before game time. Many patrons arrive several hours early to ensure they get their "little taste of heaven" before the stand runs out of hot dogs.
One day Horatio approached the old man when he is shutting down the stand for the day and asks the man the secret of his success. The elderly entrepreneur proudly boasts about the "trade secret" that he invented in the "Old Country." The old man boasts he immigrated to the U.S. with little more than the "trade secret" and the clothes on his back but now he "wants for nothing."
It turns out that the old man has no living relatives and he quickly takes a liking to Horatio. Horatio reminds the elderly hot dog vender of himself when he journeyed to America decades before in search of his fortune. Alas, the old man is about ready to retire and he would like to sell the business but despite the prosperity of the business, he has no potential buyers. That is until Horatio arrives on the scene.
It seems that no one including the owner of the parking lot who rents the space to the old man is privy to the hot dog windfall that exists. That includes the IRS and the State Department of Revenue since the old man has not been reporting accurate revenues or income on the proceeds from his hot dog business. Since the aging vendor has no valid record of his revenues, no serious businessman is the least bit interested in paying any amount above the liquidation value of the old man's hot dog stand and other usable inventory.
Whenever the old man explains to potential buyers that he has been selling out of hot dogs for over 20 years, the potential buyers scoff at his claim, advancing the notion that other vendors would have seized the opportunity if such a hotdog windfall truly existed. Why in the world would he still be working at his advanced age if his business had been so successful? The old man replies without hesitation that over the years numerous hot dog vendors had set up shop but none of them had come back the following year. “They simply can not compete with his stand.” Indeed it appears just as Horatio has suspected that "Old World Franks" is not your typical hot dog stand.
The Intrinsic Value of Old World Franks and Its Intangibles
Let's assume that the old man decides to sell "Old World Franks" to Horatio. What would constitute a fair price which reflects the intrinsic value of the business? First off, Horatio is highly unlikely to be able to secure a loan to pay for the stand outright. Secondly, since the previous owner has not been paying proper taxes on the proceeds from the stand, he would not be able to simply show up at the bank and suddenly deposit a large sum of cash without arousing suspicion. The two parties acknowledge each others' problems and decide to arrange a workable solution.
Horatio and the former owner come to an agreement. They decide the price of the business will be two times the average pretax profits of the business for the four years following the sale of the business. Further, Horatio will be provided with an interest-free loan so long as he pays back the loan within a five-year period from the time of the sale. Not coincidentally, the former owner holds a lease on the parking lot where the stand conducts business which comes up for renewal in five years.
As soon as the deal is struck, the former owner reveals his trade secrets which amount to the use of steamed buns, a hot dog which contains a liberal amount of red dye and most importantly the "secret sauce" for the hot dogs. The former owner claims that no one outside the "Old Country" knows the ingredients in the sauce and the extent of its addictive effect on connoisseurs of frankfurters.
At this point in his life, Horatio has no clue about the concept of goodwill from an accounting perspective; however, he is acutely aware of the enormous value of the intangible assets which the hot dog cart business possesses. Specifically, the location of the business in relation to Busch Stadium and the unique taste the hot dog offers in relation to its competition.
Horatio also acknowledges the value of the lease which the old man possesses which allows him to conduct business in a prime location for a minimum period of five years. His greatest fear is that the loss of that location would destroy the earnings power of the business in the longer term, although he is confident that he will record at least five years of excellent profits while the current lease remains intact.
So what is a fair estimate of the intrinsic value of "Old World Franks?" The answer is not as nearly as easy as estimating the future revenues and profits based upon the past results of the hot dog stand. I will return to the underlying value of the business after I take a short diversion into formal accounting for intangibles.
From a strict accounting perspective, the amount of the sale price over and above the sum of the net tangible assets (total tangible assets minus total intangible assets) must be listed on the balance sheet of a business as either goodwill or intangible assets.
Since FASB 142 was enacted about a decade ago, goodwill and other intangibles which do not contain a definable life span are not subject to amortization. In other words they are not expensed on a regular basis; rather they are tested for impairment annually and written down only if they are deemed to have lost their economic value. If they are not impaired, they do not affect the income statement in terms of profit, or the balance sheet in terms equity in the form of retained earnings.
In the case of the hot dog business balance sheet, all goodwill and intangible assets would remain on the asset ledger in full so long as a material event such as the loss of the lease did not impair their value. Asset impairment would be determined by a significant loss in the earnings power of the business as a result of the decrease in the value of an intangible asset.
According to Buffett's definition of economic goodwill which appears at the beginning of the article, the intrinsic value of "Old World Franks" lies almost exclusively in its intangible assets. The tangible assets of the business amount to only a paltry sum, for instance, its usable inventory which is comprised of such things as cups, hot dog wrappers and condiments as well as the undepreciated value of the aging hot dog cart. The true value of the business lies in its intangible assets which can only be accurately assessed through time. Their value will ultimately be reflected in the future income which they help to generate.
The underlying value of the stand is a function of its intangible assets which consist of the location of the business (so long as the lease remains intact) and the taste of the hot dog which includes its unique sauce as well as its other appealing characteristics.
Further, the profits of the stand are enhanced by the large crowds which the Cardinals draw 81 times per year; that part of the business goodwill appears to be durable in nature. However, the durability of maintaining the favorable location remains highly questionable. The length of the lease which the hot dog operator holds is his only assurance that his profits will remain intact. Therefore, the duration of the lease or a suitable alternative becomes instrumental in establishing the intrinsic value of the business.
Horatio understands little about accounting but he possesses outstanding business instincts in regard to Buffett's concept of economic goodwill. He is confident that he will figure out a way to prolong the intangible assets of the hot dog business and continue to record hefty profits long after the five-year lease expires. If that is the case, the price he paid for the business would look like a steal.
In the next episode Horatio ponders different ways to grow profits and establish a larger moat for his business.
About the author:
John EmersonI have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.