Microsoft Measures Up to These 2 Metrics

Microsoft (Nasdaq: MSFT  ) carries $13.6 billion of goodwill and other intangibles on its balance sheet. Sometimes goodwill, especially when it's excessive, can foreshadow problems down the road. Could this be the case with Microsoft?

Before we answer that, let's look at what could go wrong.

AOL blows up
In early 2002, AOL Time Warner was trading for $66.27 per share.

It had $209 billion of assets on its balance sheet, and $128 billion of that was in the form of goodwill and other intangible assets. Goodwill is simply the difference between the price paid for a company during an acquisition and the net assets of the acquired company. The $128 billion of goodwill in this case was created when AOL and Time Warner merged in 2000.

The problem with inflating your net assets with goodwill is that it can -- being intangible after all -- go away if the acquisition or merger doesn't create the amount of value that was expected. That's what happened in AOL Time Warner's case. It had to write off most of the goodwill over the next few months, and one year later that line item had shrunk to $37 billion. Investors punished the stock along the way, sending it down to $27.04 -- or nearly a 60% loss.

In his fine book It's Earnings That Count, Hewitt Heiserman explains the AOL situation and how two simple metrics can help minimize your risk of owning a company that may blow up like this. Let's see how Microsoft holds up using his two metrics.

Intangible assets ratio
This ratio shows us the percentage of total assets made up by goodwill and other intangibles. Heiserman says he views anything over 20% as worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."

Microsoft has an intangible assets ratio of 13%.

This is well below Heiserman's threshold, and a sign that any growth you see with the company is probably organic. But we're not through; let's also take a look at tangible book value.

Tangible book value
Tangible book value is simply what remains after subtracting goodwill and other intangibles from shareholders' equity (also known as book value). If this is not a positive value, Heiserman advises you to avoid the company because it may "lack the balance sheet muscle to protect [itself] in a recession or from better-financed competitors."

Microsoft's tangible book value is $45.8 billion, so no yellow flags here.

Foolish bottom line
To recap, here are Microsoft's numbers, as well as a bonus look at a few other companies in its industry:

Company

Intangible Assets Ratio

Tangible Book Value (in millions)

Microsoft 13% $45,828
Apple (Nasdaq: AAPL  ) 4% $72,183
Google (Nasdaq: GOOG  ) 12% $46,367
Oracle (Nasdaq: ORCL  ) 40% $11,399

Source: S&P Capital IQ.

Microsoft appears to be in good shape in terms of the intangible assets ratio and tangible book value. You can never base an entire investment thesis on one or two metrics, but there are no yellow flags here. If any companies you're researching do fail one of these checks, make sure you understand the business model and management's objectives. I'll help you keep a close eye on these ratios over the next few quarters by updating them soon after each earnings report.

Fool analyst Rex Moore owns shares of Microsoft. The Motley Fool owns shares of Google, Oracle, Apple, and Microsoft. Motley Fool newsletter services have recommended buying shares of Google, Microsoft, and Apple; and creating bull call spread positions in Microsoft and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

 


Read/Post Comments (2) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 12, 2011, at 2:49 PM, salrycapcasualty wrote:

    Rex -- tangible book value is a great place to start when looking at potential investments. It is not the only factor to consider, but as your article describes, might provide a solid reason not to invest in a particular company. I recently looked at purchasing shares of PG and was surprised to find a tangible book value of -$23 billion. That was the end of my research.

    Goodwill, as you stated is the difference between price paid and net assets. AAPL currently has a market cap of about $360 billion (price) and tangible book of $72 billion (net assets). See where I'm headed? AAPL shareholders in essence have $290 billion of Goodwill on their personal balance sheets. I currently own AAPL shares, but am not sure on future upside for their price. Any thoughts (not just on AAPL but on mega-cap stocks in general)? Are price to book value ratios a better measure in this instance or is there a threshold where the implied goodwill, in the market cap of a company, becomes a red flag?

    Thanks for the excellent article.

    Doug

  • Report this Comment On December 12, 2011, at 10:31 PM, techy46 wrote:

    Software companies, like Microsoft and Oracle, tend to carry a lot of intangible assets of their books realted to acquisitions. I wonder what Exchange Server, SQL Server orVisual Basic are worth? Probably nothing if you're an Apple fan.

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