An item called “Goodwill” is listed under the assets column of every balance sheet. This lesson will explain both Warren Buffett’s and Benjamin Graham’s opinion on Goodwill.
Before anything else, you need to understand what tangible and intangible assets are. A tangible asset is literally touchable. For example – plants, inventories, cash, receivables, etc. Intangible assets are untouchable like brand names, customer loyalty, patents, etc. We will study Apple’s balance sheet to further understand tangible and intangible assets.
At the top of the MSN Money webpage, type in Apple’s ticker – AAPL – and hit enter. Scroll down to the left hand side and select balance sheet, and then select interim, and then look at the 2nd quarter for Apple.
As you remember, the balance sheet is broken down into assets and liabilities. Goodwill or intangible assets are on the top portion, not under the current asset, but under the portion where the total assets are added up. You’ll see intangibles net.
Apple has 1.1B dollars listed for Goodwill and 3.6B dollars for intangibles net. The total intangible assets for Apple are 4.7B dollars.
To get the net tangible assets, take the total assets and subtract the intangibles. Another shortcut is to take the equity and subtract the intangibles, which is your intangible net.
For a company with preferred shares, (Apple doesn’t have), add the par values for all the preferred shares and then subtract that out of that total to get the net tangible assets.
Now, how could they list something that doesn’t physically exist? How do they know the value?
Let’s look at 2 invented examples. Take note that all numbers aren’t for real. One is Apple and the other is a smaller company called Best Apps. Now, Apple wants to buy best apps as a subsidiary. Their equity $100000 and their net income is $40000. Apple has presently no intangible assets listed on their balance sheet, so both goodwill and intangibles would be listed at 0. On the other hand, Best Apps’ equity is only $20000 and their net income is $10000. Remember, Apple will buy them out.
Apple is willing to pay $50000 to acquire Best Apps. They would pay more than the equity of the business for Best Apps, which is $20000 because Best Apps’ net income is $10000 a year. That’s half of their equity, but they can grow their equity with such a high net income. That ratio of net income to equity will be 50%, which is extremely high. Because of that, Best Apps can sell their company for an enormous premium.
Let’s assume that Best Apps is owned by an owner named Ted. For apple to acquire Best Apps, they need to pay $50000 to Ted. He then receives $50000 from Apple for his company and no longer has anything to do with Best Apps.
Best Apps falls under their parent company – Apple – and is now listed as an operational subsidiary. A company is not operational if it’s less than 50% ownership. In this case, Apple bought 100% of this business, so Best Apps is considered as operational.
The balance sheet of Apple used to have equity of $100000. Best Apps has $20000 of equity acquired during that buy out. On the balance sheet, the tangible equity increases to $120000. Ted is still holding $30000 in addition to the equity paid to him. That amount is just used to add an asset to Apple’s account.
Since Apple paid $50000 for $20000 of equity, there was an additional $30000 of Goodwill paid to Ted. Add that to the balance sheet, even if it was paid already. That sounds really confusing, but as we just valued that company with its intangible assets at $30000, we add that to the balance sheet daring that acquisition. The total equity is now listed as $15000.
Apple’s income before the buyout is listed at $40000. They also have an additional stream of money – the $10000-income of Best Apps. The net income for the whole business is now $50000. How was $30000 created on the balance sheet? The brand name, the customer loyalty, the patents and the employee knowledge of how to make those applications did. This is how business is done.
Prior to December 15, 2001, there was a very different way of accounting for Goodwill. Using the previous example, there was $30000 of Goodwill on the balance sheet. Before 2001, the accounting rule was that a company would have to amortize the Goodwill over a 40-year period to make it a tangible asset. Take the $30000 of goodwill divided by 40 years to come up with a payment of $750. Apple needs to pay $750 out of their income and then decrease their Goodwill by a month. Instead of the net income being reported as $50000, it would be reported as $49250. Their income is lower. The Goodwill would be listed as $29250, and then subtracted from the income statement. After a 40-year period, the Goodwill will no longer be listed onto the balance sheet and not subtracted from the income statement. There will be a boost in the net income and the EPS.
This was prior to 2001. This isn’t used anymore! The accounting rule mentioned above didn’t make sense before 2001. But after, the companies can keep their Goodwill without amortizing. How do you properly value a company when the Goodwill isn’t listed? Companies can be acquiring companies for ridiculous premiums and there’s no way of keeping track of that.
Buffett’s definition of economic goodwill is, “Businesses logically are worth far more than tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.”
What is economic Goodwill? Net tangible assets go to the bottom for your balance sheet. Whatever the equity is, subtract the intangibles and Goodwill from that, or in another case, subtract any of the par value of the preferred stocks. Most companies don’t have the preferred stocks. Look at the equity and subtract the Goodwill and intangibles to get the tangible assets. This is Buffet’s magic when assessing the baseline book value of a company.
Going back at the two companies earlier, Apple has equity of $100000 and a net income of $40000. There were no intangibles on the balance sheet at the beginning of the scenario. The return on equity and net tangible assets were the same at 40%. Best Apps has equity of $20000 and an income of $10000. The return on net tangible assets was exactly the same at 50%. You’re not going to commonly place that, because most companies have intangibles listed on their balance sheets.
Let’s figure this out for a comparison with net tangible assets. The second scene after the two companies merged, $30000 of Goodwill is listed on the balance sheet, while the return on equity is $150000. The net income is $50000. $50000 divided by $150000. The return on equity is 33%. Buffet looks at the net tangible assets and divides it by $120000 instead of $150000, and then he subtracts the intangible to get a 41.6 return.
Why is the net tangible asset important? Buffett believes that economic Goodwill is inflation proof, whereas tangible assets are not. At that last scene, when we subtracted the 30000$, how much will it grow off the tangible assets when we subtract $30000?
Buffett’s opinion of having Goodwill in the balance sheet isn’t bad. However, it goes completely against Benjamin Graham. He demonstrates this from his shareholder letter in 1972. He provides an example similar to the example we had. He compares See’s Candy to Boring Square Company. The net income of See’s Candy when he bought it in the 1970’s was $2M. The net tangible assets were $8M. His return was 25%. He compared these two with just a generic example of Boring Square Company. He said, “Let’s have same profit and net income of $2M, but their net tangible assets are higher at $18M.” Boring Square Company had little to no economic goodwill. If he were going use interest rates at 11.1% (this is exactly what the return on our net tangible assets would be for the boring square company), the market value at See’s would be $15M. The market price of Boring Square Company is $18M, which is exactly where their intangible assets are at.
Both companies have same profit margin. See’s has less than 50% of net tangible assets, yet the value of both is very similar – $15M and $18M.
This is where he demonstrates his points. Imagine that inflation occurs at 100% now. See’s Candy’s net income is previously $2M, and now it has $4M because of 100% inflation. When that happens, Buffett says not only are you making double net income, but you have to double your net tangible assets. To produce that additional $2M, you need to double your net tangible assets. After that, you have to invest $8M to make that additional $2M.
With Boring Square Company after the 100% inflation, the net income also doubled to $4M from $2M. Their net tangible assets went from $18M to $36M. You have to invest $18M to make the same exact $2M that See’s Candy had.
What impact does the market price have after the fallout?
You still use 11.1% interest rate and discount all the money back. While the market valuation for See’s Candy is $29M, it is $36M for Boring Square Company. The tangible square asset and market value for Boring Square Company are both $36M. For See’s Candy, the net tangible asset is $16M, but the market value is almost $30M. What does that all mean? How is one better than the other?
We took 8M in See’s Candy and invested it. It resulted in $6M and additional dollars have been produced in the market due to the economic Goodwill. It kept up with inflation. Boring Square Company invested $18M to get the same net income that eventually resulted in 0 additional dollars in the market price.
A lot is very confusing, especially dealing with assets that you can’t put your hands on, but this is security analysis.
The reality of Goodwill:
- Benjamin Graham’s opinions are, “If the company would end operations, the Net Tangible Assets are the only thing left to value a company. Therefore the difference between the market price and the book value is your margin of safety.”
- Warren Buffett’s opinion is, “The difference between market price and book value is the margin of safety, BUT real economic Goodwill inflation is proof and therefore adds more value to a business.”
- Preston Pysh’s opinion is “Economic Goodwill is great protection against inflation if you plan on owning your shares indefinitely. This approach should only be utilized when future earnings are strong and debt is minimal. In the end, a balance between purchasing a company with any tangible assets (for safety) and an appropriate amount of goodwill is exercised.”