Goodwill Ain't so Good
An often overlooked item on the balance sheet is Goodwill. I mean it’s just sitting there, right? It doesn’t really do anything and doesn’t move much, at least not anymore. In their zeal for analyzing the results, most people skip over the Goodwill item and head straight for the Revenues and Earnings, because that’s what drives the numbers, and therefore, stock prices.
Most of us live under the misconception that since it’s an asset, it’s a good thing. After all, isn’t that we’ve always learned: Assets = Good; Liabilities = Bad.
Ask an accountant, and you’ll get a very simple definition of Goodwill. It’s the amount of premium you pay when you buy a company. In other words, it’s the difference between the fair value of the assets of the company and the price which you pay, i.e., the premium. This difference has to go somewhere. It’s booked as Goodwill.
But accountants are different from the rest of the financial world. They look at items to see the best place to put them so that everything adds up and is nice & pretty. I’m not an accountant and I’ve only ever read balance sheets either to lend to the company or to invest in it. People who want to make decisions based on accounting statements, have a different perspective. My favorite authority on valuation, Professor Aswath Damodaran has a great write up on his blog on Goodwill.
Many people call Goodwill the “special” factor. It’s the value of the “synergies” from the acquisition the company just made. Some say it is the value of growth opportunities from the acquisition. While all of this may be true, the fact remains that Goodwill is a balance item; a plug variable.
Take for example, the 10K of Bristol Myers Squibb, a biopharmaceutical company that quotes “Goodwill represents the going-concern value associated with future product discovery beyond the existing pipeline and expected value of synergies resulting from cost savings and avoidance not attributed to identifiable assets. Goodwill is not deductible for tax purposes.”
Goodwill is More Relevant than Ever
Why am I talking about Goodwill now, when this is not new? Because the market is ripe for M&A deals, creating a massive flurry of Goodwill. It’s an important item that should be given consideration in any analysis.
As I write this in 2021, we’ve just experienced a bull market, despite the horrific pandemic, and most of the companies that are flourishing are tech-related. Tech companies have proprietary knowledge and while this should be booked as an intangible asset, more often than not, it gets booked as Goodwill when there is an acquisition.
In the last one year, I’ve personally seen a large company default and one of the early warning signs was the amount of goodwill on the books. The company did M&A deals left, right and center, and none of the banks questioned them - in part because they were getting rich off of deals and financing but also because they didn’t think that the rising level of goodwill warranted particular attention. While it’s true that there were deeper, more significant fraudulent issues with the management, the level of goodwill could have been one indicator that not all was right with the world.
Goodwill scares me. And I don’t say this lightly. After 17 years of reading hundreds of balance sheets, I can say I’ve seen situations where grief could be avoided, if only people paid a little attention to the growing “Goodwill”.
Goodwill is an Intangible Asset
Every analyst’s problem with goodwill starts with defining it. While I’ve already told you what an accountant would say, what an analyst would say depends on the type of company and what it’s trying to achieve. As rightly termed, it’s intangible - cannot be touched or felt and worse still, probably cannot be properly measured.
Hard assets or Tangible Assets at least serve a purpose. You can reliably measure them and they are meant to generate value. Goodwill on the other hand, is more someone’s perception of value.
But Intangible assets on the whole are not a problem.
All Goodwill is Intangible but not, All Intangibles are Goodwill
There are other assets that are intangible yet not Goodwill. These could be patents, long term franchise rights, or even intellectual property. These intangible assets can be measured more reliably and they produce some future benefit, just like tangible assets. In other words, they help a company make money. Sure, there are exceptions but on the whole, intangible assets other than Goodwill serve a purpose and have a more stringent policy of amortization, just as one would do with hard assets.
Again let's look at Bristol Myers Squibb, the pharmaceutical company focused on cutting-edge drugs. In 2019, the company acquired Celgene, a biopharmaceutical company with long term growth prospects. The company paid $80billion for the acquisition - of which almost $16billion was Goodwill but a whopping $64billion was intangible assets. According to the company’s 10K, the intangibles consisted of “currently marketed product rights & IPRD (in-process research & development)”.
Goodwill can have a Massive Impact on the Bottom Line
Prior to 2002, companies were forced to amortize or write-down Goodwill over a period of 40 years. Now, companies are allowed to “test for impairment” and write down the Goodwill only if they think it should be done. It’s a judgement call albeit backed by some logic. However, the impairment charge can only be amortized over 10 years now.
This presents two problems - the Goodwill can, in theory, live on the balance sheet forever if the company doesn’t feel that it should be impaired and, if the management chooses to write down, the yearly charge will be much higher.
The testing of Goodwill for impairment is also quite an abstract concept. I’ve been reading financial statements for a long time and I still have a hard time wrapping my head around this one. What I can make of it in simple terms is this: Goodwill is impaired when the so-called synergies or growth opportunities that you were meant to benefit from, are no longer there or decreased in value. This in itself signifies a much bigger problem than just the impairment charge of Goodwill.
There will be people who argue that impairment charges are non-cash and therefore, doesn’t hurt the company’s cash flows. While this is technically true, the cash outlay has already been made at the start of the acquisition deal, and a write down in later years is evidence that the deal wasn’t a good one.
Which method is better - forced amortization or subjective amortization? I can’t really decide. There are arguments in favor of both. What I do know is that Goodwill deserves a good hard look. I read somewhere - “Impairment is the mistake that accountants try to quantify”
It’s warning sign for bad decision making
When I see a company racking up Goodwill as they go, a warning bell goes off in my head because to me it feels like the management may be reckless in acquiring new companies. If the amounts are exorbitant - say 20% to 30% of the total assets, it’s definitely a warning sign that the company may be overpaying for acquisitions.
The problem with acquisitions is the timing. Most acquisitions are made when the market is having a bull run. Not only does the acquiring company have more cash but the market has a sense of optimism that the management doesn't want to miss out on. This also means that most acquisitions are made when the targets are expensive, creating a large amount of Goodwill on the balance sheet.
Another incentive for acquisitions is what the top brass gets out of it. People including the management of the company make a lot of money during an acquisition. Whether it’s a successful deal or not, will only surface sometime down the line. In the meantime, the management gets a huge pat on their back in the form of bonuses and added compensation (stock or cash).
What Should We be Doing About It?
Whether I like it or not, Goodwill is a fact of life for growing businesses, and it’s becoming more and more prevalent. But what we can do is take note of it and adjust our analysis accordingly. Now that we know the subtleties of this obscure item and how it can affect a company’s results, we need to be more vigilant.
Some of the subjective assessments that bankers and analysts tend to make are the following:
Adjust the Net Worth: Deduct goodwill from the company’s equity to arrive at a tangible net worth number that’s a better indicator of the equity and a more appropriate measure to use in computing ratios like ROIC (Return on Invested Capital) and ROE (Return on Equity). In corporate banking, we would do this to look at the company’s Debt-to-Equity ratio as an indicator of leverage.
Recognize the PE and PEG Ratios: PE and PEG ratios take bottom line earnings into account. This item includes the effect of goodwill impairment charges. As Prof. Damodaran points out, “if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.”
Rapidly increasing levels or exorbitant amounts could be a major red flag - as above, the management could be overpaying to increase their bonuses or just simply making bad judgement calls.
Large Impairments are also a warning sign that the acquisition didn’t work out and the management is likely trying to erase the mistake.
Not everything is as sinister as it seems. There may be nothing fundamentally wrong with a company having Goodwill on their balance sheet. However, the key in analyzing statements is not to ignore Goodwill. It’s an important item that can often have a major impact on earnings or a company’s growth prospects, and consequently share price.
There's always a story behind the numbers...