To say the current financial situation is tough for investors would be an understatement. During times like these, most investors would love nothing more than to neglect investing for a while and rejoin the party when more certainty reveals itself.
But now is exactly the time to roll up your sleeves and really dig in. Learn about new businesses and industries by reading annual reports. Go back and polish up your skills by analyzing financial statements. In that spirit, I thought it would be a very good idea to look into an often misunderstood balance-sheet item: goodwill.
How it works
Goodwill normally arises when one company acquires another. It represents the markup a company pays above and beyond the book value of a business. For example, suppose Company A decides to acquire Company B.
The balance sheet of Company B might look something like this:
Cash, $20 million
Inventory, $50 million
Receivables, $60 million
Property, plants, and equipment, $120 million
Payables, $20 million
Short-term debt, $20 million
Long-term debt, $100 million
Equity, $110 million
Company A decides to purchase Company B for $200 million. The net assets acquired, or the value of the assets minus all liabilities, is $110 million. Once Company A consolidates its purchase of Company B, Company A will book $200 million in assets acquired; $110 million in physical or tangible assets; and $90 million of goodwill, an intangible asset.
Since all investors are looking to buy assets inexpensively, you might wonder why a company would pay more than the value of a company's net assets to acquire it. One reason is that since book value is an accounting figure, it doesn't necessarily reflect the real value of a given company. Another could be that the buyer hopes that the target company will create more value as a subsidiary than it would on its own.
For example, when Procter & Gamble (NYSE: PG ) acquired Gillette a few years ago, Warren Buffett commented that it was a "dream deal." What would make Buffett say this, aside from the fact that his company Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) had a large position in Gillette shares and thus enjoyed a nice payday? Well, Procter & Gamble, one of the biggest consumer-products companies in the world, would be able to use its existing distribution channels to distribute Gillette's products. And Gillette was already the No. 1 razor company, so it wouldn't take much for P&G to promote the product. P&G hoped it would benefit from such added economies of scale in distribution and advertising, and that this would lead to higher profits over time.
The goods on goodwill
As I mentioned above, goodwill is an asset. But it's an intangible asset, rather than something physical that you can see and touch. Valuing intangible assets can be tricky, because their values differ from one company to the other. For example, the brand values of businesses like Coca-Cola (NYSE: KO ) , Nike (NYSE: NKE ) , and Walt Disney (NYSE: DIS ) are vital to the long-term success of those businesses. Coke is what it is because of the worldwide familiarity with its name. Nike's swoosh is just as powerful. And of course, whenever you see Mickey Mouse, you get warm and fuzzy feelings inside.
Goodwill, though, is different from other intangible assets. While it is very unlikely that brands like Coke would ever lose value (in fact, the opposite is true; the value of the brand has increased over time), goodwill can go away, and companies can respond by writing its value down in their financial statements. If a company's acquisition doesn't work out, then it may write down the goodwill associated with that acquisition. To be sure, other assets like inventory can get written down. But while companies can usually recover at least some value from physical assets, goodwill can end up being worthless to a prospective buyer -- because it only represents how the previous buyer valued the assets of the business.
As a result, I would be extremely cautious and more skeptical when examining companies with high amounts of goodwill. When the markets are sour, I wouldn't count on goodwill being worth much to anyone. Some months back, before Mr. Market really turned on the housing and credit markets, I took a look at Beazer Homes (NYSE: BZH ) to see if it was a bargain investment when it was trading at a fraction of book value. In my analysis, I valued the goodwill at zero, as the odds of paying anything for this intangible asset during these sour times were extremely low.
Value is what you get
Bargain investments do exist in today's markets, but there are many more bargain traps out there. While you shouldn't dismiss the markets altogether, you need to pay extra attention to potential investment opportunities. Your best bet is to look at companies you know about, as I'm certain most of them are trading at lower prices. Avoid sticky situations, like too much debt or high amounts of goodwill that can become worthless in tight markets. Your chances of finding value will be much improved.