When looking at publicly traded companies, one of the accounting landmines in modern valuation is a called goodwill.
You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission. -Warren Buffett
Accounting principles require fair value be assigned to a company when it is purchased. This fair value starts with the assignment of value to identifiable assets. In today’s modern financial world, often the purchase price of a company exceeds the value of the identifiable assets of the company. In order to keep balance sheets even, acquiring companies often must hold this excess of value as an asset.
Things to consider when valuing a company that has a lot of goodwill:
Even though such an asset has no apparent tangible value, public companies are required to account for it on the balance sheet. Accounting principles require that such goodwill be evaluated each year and if the value of the underlying acquisition be charged to earnings if the goodwill has suffered an impairment. Purchasing a company with a large amount of goodwill on its books is tantamount to purchasing the company’s assets and thin air (my personal opinion).
An example to consider (aka buyer beware ENDP):
Endo Pharmaceuticals (ENDP) recorded $3.5 Billion goodwill and intangible asset impairment charges in the fourth quarter of 2016. This occurred when the company’s management completed their goodwill and in-process R&D impairment tests. Using the estimated future cash flows for these areas, management stated that they had to revise their forecasts, Wall Street speak for “we had no idea that something could actually go wrong 12 months ago when we made our estimates.”
This caused the company to take a earnings loss of 14.96/share when the stock price for the company was about 12/share! The management in their conference call followed this staggering number with diluted earnings per share from continued operations of 1.97. A discussion of diluted earnings per share could merit its own post. However, for our purposes here just think that management came to the shareholders and disclosed that in ONE QUARTER they had losses exceeding the value of the company but all is good because diluted earnings are still positive. This resulted in the share price to drop about 17%. Goodwill can have a real tangible effect on a company’s value in the marketplace.
As for ENDP’s management, I am reminded of the old 1980 era film with Silvester Stallone named Oscar. After a day of trying to go straight, “Snaps” Provalone is sitting down with the bankers that are to be his new partners. His accountant looks through the contract and finds that the contract does not allow him to have a vote on the board. Snaps ends the session saying something to the effect of, “I’ve dealt with mobsters, bootleggers, and gonzos…but you bankers are scary”.
For another perspective on Goodwill and how it affects a company stock price consider Warren Buffet’s words on it in his 1983 letter to shareholders. His perspective from that letter would have called ENDP’s assignment of overvalued business purchases to silliness in the goodwill account. The lack of managerial discipline displayed by the management would be more along the lines of a “no-will” account.
I leave you with one final thought, if you consider purchasing a company in excess of its tangible assets. Lets use a company selling for 100/share and it has 5/share in earnings and 20/share in tangible assets. Consider amortizing the price of the excess from the earnings over the next forty years using straight line depreciation (5-80/40=3/share). Is the price still worth the adjusted earnings?