Understanding Goodwill

To understand a balance sheet requires that we understand every line item, what each means, and how it can be manipulated. Today we are going to look at the line item for Goodwill.

Goodwill Definition

Goodwill is one of the most commonly misunderstood line items in the balance sheet, I once met a junior investor who thought that Goodwill was the amount of money that the company had donated to charitable organizations. This unfortunately is not the case, goodwill, simply put, is the byproduct of two companies merging.

How Goodwill is Calculated

Examples are always easy ways of explaining so lets assume we have two businesses Giant Joe's Grocery and Pete's Corner Market. If Joe's wanted to buy Pete's they must first determine what Pete's is worth. If Pete's were to close their doors, pay off all debt and sell off all of their assets (trucks, stores etc.) We would arrive at the following assessment of the business:

	Pete's	Joes's
Assets	$2,000,000	$4,000,000
Goodwill	$0	$0
Total Assets	$2,000,000	$4,000,000
Total Liabilities	$1,250,000	$1,750,000
Assets - Liability	$750,000	$2,250,000

Showing up at Pete's with $750,000 isn't going to get you the company though. The company is owned by its shareholders so you need to buy the shares; so what does that cost us:

	Pete's	Joes's
Outstanding Shares	1000000	1000000
Cost Per Share	$2	$4
Shareholder Equity	$2,000,000	$4,000,000

So if Joe's buys Pete's they will have to shell out $2M to buy out the current shareholders- assuming that they accept today's stock price as the purchase price. Through the two parts we see that the company's raw value (book value) is $750,000 but that it will cost $2M to purchase the company, subtraction of these two yields us $1.25M. This is the premium that Joe's will pay for the right to buy Pete's.

When companies merge so too do their balance sheets so all of the assets get summed together, and so to do all of the liabilities. This makes sense, but where then does this $1.25M get assigned to? Goodwill.
So the consolidated balance sheet of our new business would look like this:

	Pete's	Joes's	Consolidated
Assets	$2,000,000	$4,000,000	$6,000,000
Goodwill	$0	$0	$1,250,000
Total Assets	$2,000,000	$4,000,000	$7,250,000
Total Liabilities	$1,250,000	$1,750,000	$3,000,000
Assets - Liability	$750,000	$2,250,000	$4,250,000
Assets/Liabilities Ratio	1.60	2.29	2.42

The problem with Goodwill

As you can see goodwill gets included as an asset in the business, lumped together with more tangible things like real estate, trucks, inventory etc. But is goodwill really an asset? If times were hard could you sell off goodwill to raise money?
Even more interesting is what happens to the Asset/ Liability Ratio after the merger. See the above table and compare the ratios for the two companies before the merger, and then their combined ratio after the merger. As a result of the merger the combination has generated a business that has an even better debt ratio than each did in isolation, and yet nothing has fundamentally changed.

Making matters worse, what if the company that was being bought had stock with a massively inflated price to book, this would drive up the goodwill even further and as such the assets of the business- essentially rewarding the buying company for making a foolish decision.

How you can sidestep this issue

Recalculate any of the ratios that use balance sheet and subtract out the goodwill portions, then compare the two, the truth is somewhere between. This is common practice for bond rating agencies and should most certainly play a role in your own analysis too.

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