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 -- 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 Netgear 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."
Netgear 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, which is simply what remains after subtracting goodwill and other intangibles from shareholders' equity (also known as book value, see box). If this is not a positive value, Heiserman advises you to run away because such companies may "lack the balance sheet muscle to protect themselves in a recession or from better-financed competitors."
Netgear’s tangible book value is $502 million, so no yellow flags there.
Foolish bottom line
Netgear appears to be in good shape in terms of its 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, however, 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.
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Rex Moore owns none of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Netgear. 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.