Nothing is quite as confounding when doing a fundamental stock analysis, than discovering a possibly inflated or grossly exaggerated goodwill value on the corporate balance sheet.
Sometimes it appears that goodwill is just an arbitrary number, plugged in to the balance sheet to put everything in a better light. Sometimes that is almost right! While goodwill is not an arbitrary number, it is one that can be highly subjective and there is a great deal of elbow room for manipulation of this number.
For that reason, I am always highly skeptical of companies that have an eye-popping goodwill entry on the balance sheet and you should be too. The number deserves some verification, to the extent that is possible, or you may be making a greater investment risk than you calculated.
Frankly, verifying goodwill on most balance sheets is all but impossible. Instead, you have to consider relevant mergers and/or acquisitions and formulate a realistic value for any patents acquired in the course of those mergers and/or acquisitions. The intrinsic value of the acquired company’s brand recognition plays a role as does the company’s reputation with customers. How can that be quantified? The short answer; it can’t. Goodwill is called an unidentifiable intangible asset for a reason.
Equally disturbing is the fact that such assets may have an infinite life (much like tax increases). This is a genuine concern for an investor because as we all know, patents expire yet goodwill calculations may live in perpetuity. Events during the life of a corporation may erode the brand, human capital can and will change, suppliers change, customers shift loyalties and reputations can be toppled in an instant.
One example of this is Union Carbide Corporation (formerly UCC) and its fate after the Bhopal, India disaster in 1984. A chemical leak at the plant killed nearly 4,000 (some estimates range as high as 16,000) and injured more than one-half million men, women and children. You won’t find that ticker on the exchange! Ultimately, Union Carbide Corporation was acquired by The Dow Chemical Company (DOW) , and Dow’s balance sheet, incidentally, reflects more than $12.7 billion in goodwill.
A more recent example is BP lpc’s (BP) 2010 debacle in the Gulf of Mexico, when BP’s Deep Horizon offshore oil drilling platform exploded and burned, killing 11 employees and resulting in the largest offshore oil spill in U.S. history. Incidentally, British Petroleum is reporting almost $11.9 billion in goodwill, up about $3.3 billion over what it was reporting at the end of 2010.
Other Egregious Examples
Banks are particularly adept at the practice, with Bank of America (BAC) leading the goodwill hunting pack with a nearly $70 billion goodwill entry on the year-end 2012 balance sheet. Several other major banks are guilty of this practice as well. JPMorgan Chase & Co. (JPM) is no slouch with a goodwill entry on its balance sheeting topping $48 billion at the close of 2012 and the Bank of New York Mellon ($BK) sported a goodwill entry just north of $18 billion.
The tech sector is rife with seemingly exorbitant goodwill entries on their balance sheets. International Business Machine Corp. (IBM) places an almost $24.25 billion valuation on goodwill, Microsoft Corp. (MSFT) reflects about $14.73 billion and Apple, Inc. (AAPL) , arguably the most cutting edge of these three tech giants, lists a relatively modest $1.38 billion in goodwill on its balance sheet.
I believe these examples make my point. Goodwill is a calculation subject to wild interpretations and must be a factor in the analysis of any stock offering. High goodwill numbers are not necessarily bad nor are they necessarily good. The real question is one of validity and that is exceedingly difficult to determine. Working in the invoice factoring industry with companies like CBAC Funding, I am certainly no stranger to numbers, business ratios and sundry other calculations, yet this goodwill issue is a constant source of exasperation.
The best we can do is to use our best judgment about these balance sheet entries. We have to formulate a parallel number that we can get our heads around and decide what motives lay behind the number the company provides—sinister or benign.
Back to the Definition
Keep these two points in mind as you make your evaluation.
More often than not, goodwill arises from the acquisition of another company at a cost that exceeded that company’s fair market value or net identifiable assets and may indicate that the acquiring company overpaid for the acquired company.
- Generally accepted accounting principles require that goodwill be tested annually for impairment. With this fact in mind, what year-over-year trends are you observing on the balance sheet of the company you are analyzing?
While goodwill is an unidentifiable intangible asset, the number can provide insights into the judgment and integrity of the company you are analyzing. Viewed from this perspective, it can prove to be valuable tool in the course of your evaluation and analysis.
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