Goodwill Accounting and Magic Formula Investing, Part 1
Goodwill is an accounting concept anyone who has investigated financial statements has likely encountered. This 2-part "mini-series" of articles will describe what goodwill is, how it is accounted for, and how it is largely ignored by the Magic Formula screening strategy, sometimes unfortunately for investors. This first article will concentrate on what goodwill is and how it is accounted for.
Goodwill usually shows up in the balance sheet as a long-term asset on its own line item entitled, simply, "Goodwill" (naturally). So the first question is: what does this asset value represent? For the purpose of simple example, lets say that company "Buyer Inc." buys 100% of company "Target Inc." (no, not that Target - TGT!). Let's also say the purchase price was $500 million dollars, all in cash.
When a company purchases more than 50% of another company, it is required by accounting laws to consolidate all of the assets and liabilities of the purchased firm. In this case, Buyer Inc.'s 100% interest meets this criteria. Therefore, all of Target Inc.'s accounts receivable are consolidated into Buyer Inc.'s accounts receivable, all cash holdings are consolidated, all accounts payable are added together, and so forth. In this manner, the two companies merge their tangible assets and liabilities. Nothing special about that.
However, it is very rare that an acquiring company pays just book value for another firm. In this case, the value of Target Inc.'s offices, warehouses, stores, computers, etc. - minus the money it owed to suppliers and creditors - was about $250 million dollars. This is the net asset value, or book value, of Target Inc. Therefore, Buyer Inc. thought enough of Target Inc.'s future earnings prospects that it was willing to pay twice the book value. By the way, this is far from unusual. Many, many companies in the market are valued at 3, 4, even 10 times book value! In any case, the extra $250 million that Buyer Inc. payed has to be recorded on its balance sheet to account for where the cash went. That's where the goodwill line item comes in. After the acquisition closes, Buyer Inc. will create a goodwill line item with $250 million in assets, in addition to consolidating the tangible assets of Target Inc. (This is a bit simplified, in real life things like inventory and property re-valuation take place first)
The accounting fun doesn't end there, however. For a long time (1970 to late 2001), accounting rules stipulate that goodwill accounts must be amortized (reduced) annually, in a constant amount, usually for a period of 40 years. Therefore, many companies carried an amortization charge on the income statement, which reduced earnings in a rather artificial way. Cash flow was obviously not affected. This rule was clearly flawed. In many cases the price paid above book value for an acquisition was completely rational, and in time the original amount turned out to be a bargain that shouldn't have been subtracted from, but added to! An example of this would be an acquired brand that built up a following and reputation over time. In this case, someone wanting to buy that brand from you today would have to pay an even higher premium to own it. This is what Warren Buffett is referring to when he separates "accounting" goodwill from "economic" goodwill (read The Essays of Warren Buffett for more).
The "new" rules for goodwill accounting, adopted in 2001, no longer require the 40-year amortization. Now, companies are required to look at their goodwill accounts annually and, if necessary, record any impairments to it. Essentially, the FASB is asking managers who sometimes made the overpriced acquisitions to admit to overpaying! Still, this treatment has resulted in bring out some admissions. One of the most famous is eBay's (EBAY) purchase of Skype for about $2.6 billion in 2005. Just two years later, eBay's management wrote down the goodwill account by $900 million. When you see a charge for "goodwill impairment" on the income statement, turn up your nose. If you see a pattern of these charges over several years, think hard before buying - you may have a management team more interested in building an empire than creating shareholder value.
So how does this relate to MFI? We will discuss that in part two...