Goodwill and its Amortization: The Rules and The Realities

The following entry is borrowed from Warren Buffett’s Berkshire Hathaway 1983 Chairman’s Letter as it was very informative and opened my eyes more clearly to the economic realities of goodwill. Amortization and goodwill are keys to understanding the intangible side of the financial statements.

“During inflation, Goodwill is the gift that keeps giving.”

(This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. For example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic Goodwill. So, just for the moment, forget emotions and focus only on economics and accounting.)

When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account entitled “excess of cost over equity in net assets acquired”. To avoid constant repetition of this mouthful, we will substitute “Goodwill”.

Accounting Goodwill arising from businesses purchased before November 1970 has a special standing. Except under rare circumstances, it can remain an asset on the balance sheet as long as the business bought is retained. That means no amortization charges to gradually extinguish that asset need be made against earnings.

The case is different, however, with purchases made from November 1970 on. When these create Goodwill, it must be amortized over not more than 40 years through charges – of equal amount in every year – to the earnings account. Since 40 years is the maximum period allowed, 40 years is what managements (including us) usually elect. This annual charge to earnings is not allowed as a tax deduction and, thus, has an effect on after-tax income that is roughly double that of most other expenses.

That’s how accounting Goodwill works. To see how it differs from economic reality, let’s look at an example close at hand. We’ll round some figures, and greatly oversimplify, to make the example easier to follow. We’ll also mention some implications for investors and managers.

Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars.

Thus our first lesson: businesses logically are worth far more than net 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.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.

Let’s return to the accounting in the See’s example. Blue Chip’s purchase of See’s at $17 million over net tangible assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years to amortize that asset. By 1983, after 11 years of such charges, the $17 million had been reduced to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also 60% of See’s. This ownership meant that Berkshire’s balance sheet reflected 60% of See’s Goodwill, or about $7.5 million.

In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting as contrasted to the “pooling” treatment allowed for some mergers. Under purchase accounting, the “fair value” of the shares we gave to (or “paid”) Blue Chip holders had to be spread over the net assets acquired from Blue Chip. This “fair value” was measured, as it almost always is when public companies use their shares to make acquisitions, by the market value of the shares given up.

The assets “purchased” consisted of 40% of everything owned by Blue Chip (as noted, Berkshire already owned the other 60%). What Berkshire “paid” was more than the net identifiable assets we received by $51.7 million, and was assigned to two pieces of Goodwill: $28.4 million to See’s and $23.3 million to Buffalo Evening News.

After the merger, therefore, Berkshire was left with a Goodwill asset for See’s that had two components: the $7.5 million remaining from the 1971 purchase, and $28.4 million newly created by the 40% “purchased” in 1983. Our amortization charge now will be about $1.0 million for the next 28 years, and $.7 million for the following 12 years, 2002 through 2013.

In other words, different purchase dates and prices have given us vastly different asset values and amortization charges for two pieces of the same asset. (We repeat our usual disclaimer: we have no better accounting system to suggest. The problems to be dealt with are mind boggling and require arbitrary rules.)

But what are the economic realities? One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition of See’s were not true economic costs. We know that because See’s last year earned $13 million after taxes on about $20 million of net tangible assets – a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill increased in irregular but very substantial fashion.

Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.

That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in “honest-to-God” assets. Could less really have been more, as our purchase price implied? The answer is “yes” – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.

But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled “No-Will”. Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an “asset” just as if the acquisition had been a sensible one.

* * * * *

If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest one final item to ponder.

 

Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per share, or 25%.

 

With such economics, it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of the entire business.

 

Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate “true” earnings per share? And, if so, should the new “true” earnings of $3 per share cause him to rethink his purchase price?

* * * * *

We believe managers and investors alike should view intangible assets from two perspectives:

    1. In analysis of operating results – that is, in evaluating the underlying economics of a business unit – amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operation’s economic Goodwill.

      1. In evaluating the wisdom of business acquisitions, amortization charges should be ignored also. They should be deducted neither from earnings nor from the cost of the business. This means forever viewing purchased Goodwill at its full cost, before any amortization. Furthermore, cost should be defined as including the full intrinsic business value – not just the recorded accounting value – of all consideration given, irrespective of market prices of the securities involved at the time of merger and irrespective of whether pooling treatment was allowed. For example, what we truly paid in the Blue Chip merger for 40% of the Goodwill of See’s and the News was considerably more than the $51.7 million entered on our books. This disparity exists because the market value of the Berkshire shares given up in the merger was less than their intrinsic business value, which is the value that defines the true cost to us.

Operations that appear to be winners based upon perspective (1) may pale when viewed from perspective (2). A good business is not always a good purchase – although it’s a good place to look for one.

 We will try to acquire businesses that have excellent operating economics measured by (1) and that provide reasonable returns measured by (2). Accounting consequences will be totally ignored.

 At yearend 1983, net Goodwill on our accounting books totaled $62 million, consisting of the $79 million you see stated on the asset side of our balance sheet, and $17 million of negative Goodwill that is offset against the carrying value of our interest in Mutual Savings and Loan.

 We believe net economic Goodwill far exceeds the $62 million accounting number.

 Source: Warren Buffett, 1983 Chairman’s Letter, Appendix 

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You’re Already a Lottery Winner

It is easy to get stressed out, bummed or overwhelmed by the day to day problems, or the ever growing list of things to do, thrown at you on a routine basis. Next time you’re faced with sadness, anger, or envy remember you have already won and that it can be as simple as changing the perception or attitude in which you approach these situations that ultimately delivers the outcome.

“Perception is reality.” Lee Atwater

It is easy to blame the government, capitalism, past actions, other people or any other conceivable reason that fits your needs. While the fact of the matter is, you have already won the global ovarian lottery the day you were born in North America.  It is fairly simple to understand around the time of my birth at the beginning of the 90s global population was roughly 5.3 billion. Meanwhile American & Canadian population was 248.7M and 27.5M respectively or 276.2 million total. Now if we simply divide Canadian and American population sums by global population at the time of birth we get the following:

276 200 000 / 5 300 000 000 = 0.0521132
0.0521132 x 100 = 5.21132% chance of being born in Canada or United States

Next time you hear about the 1% and growing inequality within your country remind yourself you are already part of the top 25% globally and true inequality needs to be addressed all over the world. Food, water and shelter are unfortunately unavailable to a majority of humans that do not have the financial capabilities or a job to pay for these basic necessities to survive.

How about being remembered as the generation that changed that?

6 Quotes from Warren Buffett: 1982 Berkshire Hathaway Shareholder Letter

WarrenThe first quote and simplest to understand pertaining to business management and the decisions that are made that are not beneficial to the acquiring shareholders is the following: “Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of it.  And if it isn’t smart to sell all on such a basis, they should ask themselves why it is smart to sell a portion.” But we constantly see dilutive equity offerings executed for the sole purpose of acquiring a less attractive (not at the time) business at the expense of the shareholders. As Warren explains in the letter he would never offer part of his ownership stake for less than intrinsic value. Ask yourself does it make sense to sell $1 for 0.50 cents ?

“Don’t ask the barber whether you need a haircut.”  Making sure interests align is key, being aware of the biases that are produced by so many of us constantly is essential in navigating the world of individualistic societies, where everyone is trying to get one step further ahead at the expense of a fellow human.

“The thrill of the chase blinded the pursuers to the consequences of the catch.” As seen to often by dilutive, value destroying management, in it for a bigger bonus or a larger slice of gluttony pie. Management is a key component of any business and it is best to make sure their interest align with yours (maximizing shareholder value not employee compensation)

Acquiring a business or a portion of the ownership is very exciting especially when bargains are littered in a non-effiecient market, produced by more often than not, buyers forced to sell at an unpleasant time due to urgency, liquidity, or usually the case, leverage and can be had by any individual willing to pay the requested price at the time sought. “Fractional-interest purchases can be made in an auction market where prices are set by participants with behaviour patterns that sometimes resemble those of an army of manic-depressive lemmings.” For clearer clarification of the quote please see the definition of a lemming below.
1) “any of various small, mouselike rodents of the genera (Lemmus,Myopus,  and Dicrostonyx,)  of far northern regions, (as L. lemmus,  ofNorway, Sweden, etc.,) noted for periodic mass migrations thatsometimes result in mass drownings.” – Dictionary.com 

A very humorous analogy of goals, business benchmarking, business performance and management execution can be summed up in the following quote from Warren. “Just shoot the arrow of business performance into a blank canvas and then carefully draw the bullseye around the implanted arrow.” As we see too often today obscure comparisons and fictional benchmark standards are implemented just in time, as the drum of the old benchmark beats a loud thump of failure and is swept under the rug. It is casually replaced by a “new” “better” and “more accurate” benchmark, only to be changed again at the first sign of defeat.

The last quote is in regards to valuation of a business using accounting statements and how investors and management often put to much focus and labor into the analysis of these numbers, which more often than not, are implemented in a questionable (liberal) manner. “It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.”

1982 Berkshire Hathaway Annual Shareholder Letter (HERE)

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Adding Tools to Your Mental Toolbox: Accounts Receivable, Inventories & Sales

 *Sales/Inventory = Inventory Turnover
NOTE: (Beginning of the period inventory + End of period inventory /2) will also lead to more accurate interpretation of seasonal inventory levels.

“An investment in knowledge pays the best interest.” – Benjamin Franklin Image

I like to think of learning, educational material, events experienced, physically practising activities, reading and watching videos as tools that produce intangible pockets of wisdom to be kept in your mental tool box. When it comes to fundamentally assessing a public company, there is many steps involved, from initial scans, to basic ratios and financial statement analysis, the process can be intimidating.

But it is your hard earned money that you haven chosen to invest and partake in future profits the company delivers and it is your duty to conduct diligent research or pay someone else to do so. Whenever you are buying, someone is selling. Whenever you are selling, someone is buying. It is best to take this into consideration when doing your research because you are essentially telling the market you know more.

Why is Inventory Analysis important?

Excessive inventories produce additional carrying costs, which in turn hurt COGS as well as increase the exposure of write offs (damage & shrink). When inventory trends higher in relation to the companies sales, write offs and markdowns can occur quickly, negatively impacting earnings.

Bloated inventories can also reveal slowing production in the near future. Although finished goods, raw materials and work in progress (WIP) are the better items to scrutinize reported in the 10-Q or 10-K (if available for SEC reporting). When finished goods are being produced at a higher or unsustainable rate in comparison to sales and raw materials, it is a red flag that production is on the verge of decline. On the other hand as raw materials and sales increase in relation to finished goods, production is likely to increase in the near term.

Inventory represents an investment by the business that currently is earning 0% ROR (rate of return) and is an asset that must be managed efficiently. I find this analysis works best in consumer sensitive, technology, and industrial cyclical companies. Comparisons are best completed peer to peer within the same industry for obvious industry differences. Inventory management is crucial in business as cash is tied up and inventory must be produced within moderate accuracy of sales outcomes (not forecasts) or blunders may occur.

I highly recommend adding this tool to your list of ratios when analyzing potential investments or operating your own business, efficiency is one of the golden keys of business success.

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Video

Times They Are A Changing

The market continues to further stretch to the upside with the S&P500 over the last 4 weeks running up 130 points and the DJIA rallying over 800 points in the same period. The rally this week was partly fueled by comments from David Tepper on CNBC, a hedge fund manager, suggesting that he remained bullish. Is it crazy to think “professional” money managers would buy on statements from another fund manager, legendary or not. Logic easily goes out the window when emotions are so high and can often evoke “irrational exuberance” or the twin brother discouragement when on the other end of the spectrum.

Many market participants who have been waiting for a market pullback have not had the chance in 2013 as we haven’t had 3 consecutive down days this far. Sidelined cash holders are no doubt in panic buying mode as the market seems to have left them behind. Short sellers have been handed their heads and completely eradicated for the time being stepping aside from the market.

It may seem like a perfect storm for Equities to run higher, but I have felt it is more likely a turning point in the markets in the coming days/weeks. It is very strange behaviour to see market cycles move in an almost straight line up or down.

We have had an enormous and quickly staged rally from the 1400 level in S&P with modest earnings and dividend growth and most of the companies 2013 earnings expectations loaded for the back half of the year.

The rally thus far has clearly been driven by global easing by almost all central bankers, Japan in particular with the Nikkei up over 43% YTD on a massive stimulus plan (same size as US). I do not see this type of move as anywhere near sustainable and have raised cash in the recent months, being selective of what I continue to hold, carefully scrutinizing my personal research thesis’s.nikkei

I am not calling a market top and as @ReformedBroker said on Twitter “I do not wait for market pullbacks, I wait for dividend payments, you can put that on my tombstone.”

With record low bond yields and so many sidelined managers waiting with piles of cash, this could just be the start to another leg in the 09-13 bull market. I don’t pretend to know where the market is heading in the short-term but one thing I know is it will be higher 30 years from now.spy

“In the short run, the market is like a voting machine, but in the long run, the market is a weighing machine.” – Benjamin Graham