Can You Count on Goodwill?

Goodwill is hard to count on because its value can come from abstract and often unreliable things, like ideas and people, neither of which are guaranteed to work for a company forever. Determining goodwill also involves some time to work around accounting conventions. When analyzing company fundamentals, investors should try hard to get a sense of where the value of a company's goodwill is coming from and where it might be going. (See also: Financial Concepts: Introduction.)

Given its hazy nature, goodwill is designated as an intangible asset. It is a blanket term that represents, in one lump sum, the value of brand names, patents, customer base loyalty, competitive position, R&D and other hard-to-price assets a company might own. It encompasses all the factors above and beyond book value that make investors willing to buy a business.

Investors need to worry about goodwill when a company buys another company and pays more than the fair market value of net assets. Let's say you invest in Thunder Inc. The company has $100 million in cash with no other assets or liabilities and therefore a book value of $100 million. Now, imagine that Thunder Inc. buys Lightning Inc. for $100 million. Lightning Inc. has a whole host of different assets with a fair market value of $100 million, liabilities of $50 million and a book value of $50 million.

Before the deal, Thunderbolt's book value amounted to $100 million. Post-purchase, Thunderbolt emerges with $100 million in assets and $50 million in liabilities, which means its book value (assets minus liabilities) is just $50 million. Here is where the goodwill accounting convention makes its appearance. Goodwill is the amount over and above the fair market value of Lightning's net assets. To account for the purchase price of $100 million, a total of $50 million worth of goodwill will be tacked onto Thunderbolt's balance sheet.

All this accounting work leaves Thunderbolt investors in a tough position. How much is Thunderbolt's goodwill really worth? It might just turn out to have a brand name or customer base worth $150 million. Mind you, it could be that Thunderbolt simply paid too much. It's very hard to know. (See also: What Makes an M&A Deal Work?)

If a company is worth more than its tangible assets, it could be because the owners have been able to add value in less tangible ways. For instance, the bulk of Coca-Cola's share value is not in its bottling plants, but in the brand name that the company has built up over many years. Or think of Microsoft, with much of its value coming from its near-monopoly position in PC software.

Accounting rules at one time assumed that the value of intangibles depreciate over time, in the same way that tangible assets get worn out. Nowadays, in recognition that many types of goodwill don't wear out, companies no longer automatically take charges against goodwill each reporting period. Instead, they must re-examine the value of goodwill each year. If the goodwill is worth as much as what it was originally paid for, the value is left alone. On the other hand, if an acquisition eventually turns out to be worth less than what management originally paid for it, the company will then reduce its value or write-off its value entirely.

An infamous example of a company having to reduce goodwill is AOL Time Warner, which admitted to investors in early 2003 that the value of its troubled America Online unit was overstated. It reported a 2002 net loss of $98.7 billion after taking a fourth-quarter charge of $45.5 billion, attributed mostly the value of the troubled America Online unit. The write-down, creating the biggest annual corporate loss in history, was more than twice what Wall Street had anticipated. overpaid for when AOL and Time Warner merged.

If a company management team is constantly writing down goodwill, it is giving off a telltale signal that management has made poor decisions. Investors may want to rethink the investment.

If a business is acquired for a price below the fair value of its tangible assets, the margin is sometimes called "badwill" or negative goodwill. Such purchases are rare; by nature, they imply a bargain, but they do happen. When, however, there is even more badwill than the buyer thinks, there is no bargain for investors. (See also: Impairment Charges: The Good, the Bad and the Ugly.)

It is worth the effort to examine goodwill. The account is located on the balance sheet, but more often than not it is lumped together with other assets and disclosed in the footnotes at the end of the financial statements. Once identified, it should be handled with care, and the sources of its value scrutinized.