Friday, October 9, 2009

How to Interpret Goodwill On the Balance Sheet

Imagine that you purchased a home with the knowledge that you were paying $50,000 more than its true market value. Now imagine that as part of your personal financial planning, you decide create a personal balance sheet, and you list that $50,000 as an asset. This would make absolutely no sense right? The answer is, it depends upon whether you are an individual, or a publicly traded corporation. For the individual, that $50,000 on your balance sheet is nothing more than proof that you are an idiot. A corporation however, would be well within their rights under generally accepted accounting principals (GAAP) to record that $50,000 as an asset on its balance sheet, and label it "goodwill".

Technically, the above example is not entirely representative of the concept of Goodwill. Goodwill refers to the amount paid, when acquiring a company, that is in excess of fair value of the firm's net assets. Let's say the fair value of Company A's net assets are $7B, and Company B purchases Company A for an amount which corresponds to $10B. After the transaction, Company B will be left with $3B worth of Goodwill on its balance sheet. Supposedly, this amount represents some sort of intangible value that Company B believes will exist in the combined company. The problem as I see it is that Goodwill has the potential to inflate the perceived level of Shareholder's Equity in a corporation. Let's say Company X has $10B worth of assets, $9B worth of liabilities, and $1B worth of shareholder's equity. Now, assume that Company X has $3B worth of Goodwill recorded as assets. If this amount is a non-cash asset, and furthermore is unlikely to ever be converted into anything of value to the company, then couldn't the argument be made that Company X actually has -$2B worth of equity?

These cases do exist in real life. Take URS Corporation (URS) for instance. URS "provides engineering, construction, and technical services to the power, infrastructure, Federal, and industrial and commercial market sectors in the United States and internationally." As of January 2nd, 2009, URS reported $7B in assets, $3.15B of which is classified as goodwill. A little investigation indicates that that a substantial portion of this goodwill is attributable to the company's 2007 acquisition of Washington Group International. Given that none of this goodwill has been written down since 2007, one might ask: why? Well, my bet is that URS is benefiting from one of the luckiest acquisitions that any company could have made in 2007. The reason being, Washington Group - as the name might suggest - specializes in contracts through the Department of Energy, most notably nuclear waste management and disposal contracts. With the cyclical resurgence of new nuclear construction in the United States, and Uncle Sam's status as a profligate spender, it appears that URS acquired a company that will be uniquely resistant to recessions over the next couple decades. So, for now at least, we can say that the goodwill on URS's balance sheet is reasonably justified. This isn't always the case.

In 2008, Sprint (S) admitted that it's 2004 acquisition of Nextel was one of the poorest decisions ever made by a US corporation. Sprint didn't actually say that, but their balance sheet did; the company wrote down all of the Nextel related goodwill on it's balance sheet - all $29.5B worth. Way to go.

The moral of this story is that not all goodwill is created equal; it all depends on whether or not the acquisition which created the goodwill will ultimately be judged as a successful venture for the company. Such a determination is of course exceedingly difficult to make, as things like cultural incompatibility between the acquirer and the acquired can potentially ruin a deal that might have otherwise looked great on paper. Because of the obvious uncertainty in these situations, I personally tend to shun any stocks where the ratio of goodwill to total assets gets too high. How to define too high? I wouldn't issue a bright line rule on this one, but would just say that there is a 100% positive correlation between the goodwill-to-total assets ratio, and my level of discomfort with the company's fundamentals.

*Update: I realized that I neglected to mention a critical - and curious - component of goodwill. Unlike many other intangible assets whose "life" is fairly well defined, goodwill on the balance sheet is not amortized in any systematic way over time. Rather, it is subjected to an annual impairment test whereby the market value of the lingering goodwill is determined, and in the event that market is lower than book value, the goodwill must be written down to reflect this reality. Sphere: Related Content

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