Ill Will Towards Goodwill?

Although Goodwill elicits apprehension and confusion; the accounting for Goodwill is a natural result of the core ideas of valuation--we value companies considering their future cash flows, not just the net assets they currently have. Moreover, setting aside the label, the treatment for Goodwill is effectively the same treatment we use when purchasing stocks or many assets—assets are initially recognized at their market values.

A poll that I conducted last weekend on LinkedIn showed that roughly 75% of participants thought that a large amount of Goodwill indicated overpayment. Conversely, only 23% of participants made the same overpayment conclusion when the question was asked with the same setup, but without the term Goodwill, buying a stock for more than its net asset or equity value. What is the reason that we are inconsistent?

We certainly want to be discerning with valuations and not overpay for any assets, but our responses to paying more than the net asset value should be the same whether or not the word Goodwill is included as this discussion covers.

Importantly, the main reason that we value companies at more than their net asset value is that we are valuing the company’s future performance, not just the value of its net assets (net assets are assets minus liabilities or equity). That is, with Goodwill we are acknowledging that a company can be the present value of expected future performance... or its future cash flows.

This is the future revenue, offset by expenses, which translates to future cash flows, appropriately discounted to consider the risk, as captured by this summary graphic.

If you'd like more here is a more involved graphic of model for estimating intrinsic value or you can access this slide deck offering a clear-eyed approach to valuation.

Moreover, the balance sheet is not designed to provide us with value for the company, but to provide information on the company’s resources (assets) and claims to the resources (liabilities).

The idea of valuing a company above its net asset value is not, at all, unique to an acquisition that gives rise to Goodwill. Moreover, overpayment is not an issue specific to Goodwill, acquisitions or accounting, but is a challenge we routinely face when valuing any company, independent of the accounting treatment.

Goodwill feels different and can be confusing, so much so that some allow their confusion to treat Goodwill as a dirty word and deride the process. Should this illwill really be focused on Goodwill or is it just a feeling that naturally arises when we are reminded that valuation is inherently uncertain and ambiguous? Having these feelings is ok, but let’s not misdirect them.

Goodwill is the Market Value of the company purchased minus the market value of identifiable Net Assets. Stated differently for emphasis:

Purchase Price Paid in Market-Based Transaction – Market Value of Net Assets Obtained = Goodwill.

That is, Goodwill mathematically arises as we have market data for the other pieces and the equation needs to balance to represent the business reality.

Yes, this is a plug, but before the criticism of this approach or the assumption that this is overpayment, let’s consider whether we would apply the same criticism if we changed some of the labels? If you taken our Financial Statement Analysis class at the Texas McCombs School of Business , I hope it is quite clear that we try to focus on underlying business performance and fundamentals, not just getting distracted by stickers and labels… how else could we survive in a world overrun by CAGRs, EBITDAs and other intentionally inaccessible processes!

Let’s work through this (this is not a deep dive into ASC 805, but a general discussion to highlight similarities):

Say we have an acquisition and the market-clearing acquisition price is $178 and the market value of the identifiable net asset value is $3, the Goodwill is $175. How do we account for this transaction?

That is, cash goes down $178 and some assets go up $3 and another asset, called Goodwill, goes up $175. Total assets are unchanged as we spent $178 cash and received assets that the market priced (collectively) at $178.

Here Goodwill is a substantial part of the transaction and related to what we paid over net asset value. Goodwill is not large given the accounting, but as the market valued this company as significantly more than its net assets. Here we lump most, but not all, of this together into one asset account, Goodwill.

• Is there something wrong or even different with this treatment?
• Is there something wrong with the fact that the balance sheet balances here?
• Does the existence of Goodwill itself indicate overpayment?

Before we answer these questions, let’s offer another example to ensure our thoughts are consistent:

Say we purchase Apple’s stock and with a market-clearing price is $178 (roughly its value when I started writing this) and the market value of the company’s net asset (or equity) value is $3. How do we account for this transaction?

Cash goes down $178 and assets, here likely called Trading Securities, goes up $178. Total assets are unchanged as we spent $178 cash and received an asset that the market priced at $178.

Here the amount paid for Apple is significantly greater than the net assets (or equity). That is, the market is valuing Apple as much more than its net assets, yet we lump it all together into one account.

• Should we have ignored the market price of Apple in this transaction?
• Should we have recorded only the amount we spent on Apple’s book value of equity?
• Is the fact that we paid more than its book value of equity alone a good indicator of our purchase being overvalued?

(I would absolutely buy Apple at $3/share, but I don’t think anyone is selling at that price… if you own Apple’s stock and want to be saved from your “Goodwill overpayment,” I’ll even double the price to $6 and take any shares off your hands.)

Again, in in the vast majority of cases companies are valued at more than their net asset values as we value their future potential.

In many ways, the initial recognition of Goodwill is not only the same as when we buy individual stocks as we covered here, but the same as many assets: at the initial recognition of many assets we decrease cash and increase assets for the market-clearing price, the price that we actually paid when we obtained the asset.

If we wanted to do away with Goodwill, would we have to forbid valuation based on expectations of future performance? Would we require that when stocks are purchased, we only recorded the net asset value, not the actual market value of the stocks? What about other assets that we bring on to the balance sheet using their market values?

This straightforward video from 1999 featuring Warren Buffett and Charlie Munger captures the essence of this discussion (and ASC 805) quite well (Goodwill represents the results of the market transaction and should be tested for impairment, not amortized):

https://www.youtube.com/watch?v=QDj699ZfoS8

Is there value in understanding how and why things are done and noting similarities? In some ways, does a criticism of Goodwill come across as more of a rejection of valuation as based on future expectations or a critique of market prices not reflecting reality, than a critique of accounting.

Alternatively, one can see Goodwill for what it is: accounting’s willingness to synthesize and use the knowledge from related areas to best reflect reality: we try to estimate future performance and use market data as reflections of these expectations. If this troubles or confuses, that’s ok, but let’s focus on efforts and energies on what gave rise to the Goodwill, valuation itself, not on the way accounting captures the results of valuation.

Feel free to post questions or let me know what I missed or overlooked.

1 more down, 10,000 more to go.

Take care,

PB