Can you count on goodwill?

Goodwill is difficult to rely on because its value can result from abstract and often unreliable things like ideas and people, none of which are guaranteed to work for a company forever. Determining goodwill also takes some time to get around accounting conventions. When analyzing company fundamentals, investors should strive to get a sense of where the value of a company’s goodwill is coming from and where it could go. (See also: Financial Concepts: Introduction.)

Because of its fuzzy nature, goodwill is reported as an intangible asset. It’s a blanket term that, together, represents the value of a company’s brand names, patents, customer loyalty, competitive position, research and development, and other hard-to-price assets. It includes all factors that go beyond the book value and that arouse investors’ willingness to buy.

Risks of goodwill in M&A

Investors need to worry about goodwill when one company buys another company and pays more than the market value of net assets. Let’s say you invest in Thunder Inc. The company has $ 100 million in cash with no other assets or liabilities, so it has a carrying amount of $ 100 million. Now imagine if Thunder Inc. buys Lightning Inc. for $ 100 million. Lightning Inc. has a variety of assets with a market value of $ 100 million, liabilities of $ 50 million, and a book value of $ 50 million.

Prior to the transaction, Thunderbolt’s book value was $ 100 million. Upon purchase, Thunderbolt comes out with $ 100 million in assets and $ 50 million in liabilities, meaning its book value (assets minus liabilities) is only $ 50 million. This is where the Goodwill Accounting Convention comes into play. Goodwill is the amount that exceeds the market value of Lightning’s net worth. To account for the $ 100 million purchase price, a total of $ 50 million in goodwill is added to Thunderbolt’s balance sheet.

All of this accounting work puts Thunderbolt investors in a difficult position. How Much is Thunderbolt’s Goodwill Really Worth? It could turn out to have a brand name or customer base of $ 150 million. Mind you, it could be that Thunderbolt just paid too much. It is very difficult to know. (See also: How does an M&A deal work?)

If a company is worth more than its tangible assets, it could be because the owners have been able to create value in less tangible ways. For example, the majority of Coca-Cola’s stock value is not in the bottling plants, but in the brand name the company has built over many years. Or think of Microsoft, which gets much of its value from its near monopoly on PC software.

Goodwill amortization

Accounting standards previously assumed that the value of intangible assets would decrease over time, just as property, plant and equipment would wear out. Given the fact that many types of goodwill do not wear out, companies no longer automatically charge goodwill every reporting period. Instead, they have to re-examine the value of the goodwill every year. If the goodwill is worth as much as it was originally paid for, the value is left. However, should an acquisition turn out to be ultimately worth less than management originally paid for it, the company will reduce its value or write off its value entirely.

A notorious example of a company looking to shed its goodwill is AOL Time Warner, which admitted to investors in early 2003 that the value of its troubled America Online unit was overrated. The company posted a net loss of $ 98.7 billion in 2002 after posting a $ 45.5 billion charge in the fourth quarter, largely attributed to the value of the ailing America Online unit. The depreciation, which caused the largest annual corporate loss in history, was more than double what Wall Street expected. overpaid for the merger of AOL and Time Warner.

If management is constantly writing goodwill, it is a tell-tale signal that management has made bad decisions. Investors may want to reconsider the investment.

Paying the opposite of goodwill

When a company is acquired at a price below the fair value of its property, plant and equipment, the margin is sometimes referred to as “badwill” or negative goodwill. Such purchases are rare; by nature they imply a bargain, but they happen. However, when there is even more malice than the buyer thinks, there is no bargain for investors. (See also: Depreciation Charges: The Good, the Bad, and the Ugly.)

The bottom line

It is worth checking out the goodwill. The account is on the balance sheet but is mostly shown along with other assets in the footnotes at the end of the financial statements. Once identified, it should be treated with care and the sources of its value questioned.