33. What is Goodwill on a Balance Sheet Video Lecture | Become an Expert: Value Investing - Business Basics

welcome to course three unit six lesson
six
what is goodwill so for any investor
that spent a lot of time looking at
balance sheets they're gonna have
noticed an item in there called goodwill
listed under the asset column and the
purpose of this lesson is to explain
Warren Buffett's opinion on goodwill and
also Benjamin Graham's opinion on
goodwill so hopefully as we go through
this it'll all make sense to you and if
you have any questions make sure you ask
it on the forum so before we can start
describing what goodwill is we have to
understand what tangible assets versus
intangible assets are so over on the
left you can see that a tangible asset
is something that you can actually lay
your hand on and touch so this would be
your plan your inventory cash
receivables all those kinds of things
now receivables even though you can't
touch them maybe right now eventually
you will be able to so intangible assets
are those things that you can't touch
and that would be your brand name
customer loyalty patents things like
that so in order to give you an example
of where to find intangible assets on a
balance sheet versus tangible assets
we're gonna go ahead and pull up Apple
and I'll show you their their balance
sheet and show you where these numbers
are at okay so here we are at the top
level MSN Money webpage and so what
we're gonna do is we're just going to
type in the ticker for Apple which is a
APL and we'll go ahead and hit enter and
it takes us to the top level page for
the Apple company and so what we're
gonna do is we're gonna scroll down over
here to the left hand side where we can
select a balance sheet and as you can
see the balance sheet has loaded we have
interim selected so we're gonna be
looking at the second quarter for 2012
for Apple so when we look at the balance
sheet as you remember the balance sheet
is broken down into assets and
liabilities and when we're looking at
goodwill or intangible assets we're
gonna find that under the top portion
here not under current assets but under
the second portion where the total
assets are added up and you're going to
see Goodwill listed and you're going to
see intangibles net okay so for Apple we
can see that they have one point 1
billion dollars listed for good
we'll and they have 3.6 billion listed
for intangibles net so if we're looking
at the total intangible assets for Apple
it would be 4.7 billion dollars if we
want to figure out what our next angel'
assets were you're gonna take the total
assets you're gonna subtract out the
intangibles which would be these two and
then you'll subtract out all the
liabilities so another shortcut is that
you could take the equity and just
subtract out your intangibles which is
your goodwill and intangible net right
here and that'll give you the same
number now for a company that would have
preferred shares which this for Apple
they don't have any preferred shares
you'd have to add up with the par values
for all those preferred shares and
subtract that out of that total in order
to get the net tangible assets so after
seeing that you might be asking yourself
how can they list something on there
that doesn't physically exist how do
they know what that value is and in
order to do this I'm just going to
demonstrate this with two different
companies here on the left-hand side
we're gonna say that we have the Apple
company and then on the right hand side
we're gonna say that we have a smaller
company called best apps and we're just
going to assume that Apple wants to buy
out best apps they want that company to
fall under there their company as a
subsidiary okay so whenever we're doing
this let's just say that the equity on
Apple is $100,000 and that their net
income for the year is $40,000 okay now
I know that those numbers aren't
accurate but we're just going to use
these to simplify this demonstration
we're also going to assume that
presently Apple has no intangible assets
listed on their balance sheet so both
that goodwill and that that intangible
would be listed as zero okay so that
when we look over at the smaller company
best apps we're gonna see that their
equity is only $20,000 and that their
net income is $10,000 okay now if we
remember apples gonna buy them out so
let's go to our next slide here
okay so let's assume that Apple was
willing to pay $50,000 in order to
acquire best apps now when we look at
that valuation of $50,000
we can understand why we would pay maybe
more than the equity of the business for
best apps which is $20,000 because when
you look at their net income of $10,000
a year you can see that that's half of
their equity and they're going to be
able to grow their equity very quickly
with such a high net income when you
look at that ratio that net net income
the equity that's our return on equity
that's going to be 50 percent which is
extremely high okay so because of that
best apps can sell their company for an
enormous premium and to be honest with
you you probably go for something like a
hundred thousand dollars opposed to
fifty thousand dollars but we're just
going to use 50 thousand for this
example to demonstrate how goodwill is
added to a balance sheet so let's also
assume that best apps is owned by a
single owner and the guy's name is Ted
and we have a picture of Ted there so in
order for Apple to acquire best apps
they're gonna pay Ted 50 thousand
dollars for the company so you can see
that payment being made to Ted for 50
thousand dollars from Apple okay after
that purchase has taken place as we look
over at Ted we can see that Ted has
received $50,000 from Apple for his
company so he's got his money he no
longer has anything to do with best apps
but what happens is his best apps now
falls under their parent company which
is Apple and best apps is now listed as
an operational subsidiary because it's
non operational if it's less than 50%
ownership but in this case Apple bought
100% of ownership of this business so
it's listed as an operational subsidiary
okay so when we go to the balance sheet
the balance sheet used to have equity
for Apple of $100,000 but as you
remember best apps had $20,000 of equity
that was acquired during that buyout so
on the balance sheet you're gonna see
the tangible equity increase to one
hundred and twenty thousand dollars okay
now when we look at the goodwill
although that goodwill wasn't brought
over to Apple if you look over at Ted
he's still holding that thirty thousand
dollars in addition to the equity that
paid them for so how are we listing that
$30,000 on there and what it is it's
nothing more than us being able to add
an asset to our account of the goodwill
that we paid over the equity of the
company so since we paid fifty thousand
dollars for twenty thousand dollars of
equity there was an additional thirty
thousand dollars of goodwill that we
paid to Ted and now we get to add that
onto our balance sheet even though we
already paid it to Ted okay
so that might sound really confusing and
how we're allowed to add money that's
not really there is might be really
confusing to people but what we did is
we just valued that company and what
it's intangible assets were and we value
the intangible assets at thirty thousand
dollars so we get to add that to our
balance sheet during that acquisition so
our total equity would now be listed as
a hundred and fifty thousand dollars
okay when we look down at the income
statement we can see that Apple's income
from before the the buyout is still
listed at forty thousand dollars and now
we also have an additional stream of
money which is best apps income of ten
thousand dollars and so our net income
for the whole business now is fifty
thousand dollars so how was thirty
thousand dollars created on the balance
sheet and this is what it is it was the
brand name it was the customer loyalty
it was maybe patents associated with
those apps who is the employee knowledge
of how to actually make those those
applications and all of those things
have value and it's very very hard to
put a value on it and this is how
businesses do it so prior to 15 December
2001 there was a very different way of
accounting for goodwill on a balance
sheet okay now we're using our previous
example since you understand that
example we have thirty thousand dollars
of goodwill on this balance sheet so
before 2001 the accounting rules were
that a company would have to amortize
that goodwill over a 40-year period in
order to make
we'll a tangible asset so you'd have to
turn that into cash over a 40-year
period and how they did that is you
would take your thirty thousand of
dollars of goodwill we divide that by
forty years to come up with a seven
hundred and fifty dollar payment okay so
what Apple would have to do in this
generic situation is they'd have to pay
750 dollars out of their income and then
decrease their goodwill by that amount
so which you what it would look like
after the first year is that instead of
the net income being reported as fifty
thousand dollars it'd be reported as 49
thousand two hundred and fifty dollars
so their income is lower it's being
reported as lower because they have to
take that seven hundred and fifty
dollars out of that profit line okay and
then the goodwill would be listed is
twenty nine thousand two hundred and
fifty dollars okay so it's also
subtracted out of the goodwill and what
you have is after a 40-year period the
goodwill would have no longer be listed
on to the balance sheet it would just go
away and then the income statement you
wouldn't have to subtract that amount
out of the income statement so you would
see like a boost in the net income in
the EPS so this is prior to 2001 this
isn't used anymore and there's a lot of
people a lot of managers money managers
very happy that this is not used anymore
as you can imagine having to amortize
that goodwill over a 40-year period is
going to have a drastic impact on your
net income and what you're being able to
report to be honest this accounting rule
before 2001 really didn't make a lot of
sense after 2001 companies can keep the
goodwill on their balance sheet without
advertising that premium so you might be
asking it okay so if they don't have to
amortize that amount and actually
materialize that money anymore how are
you able to properly value a company
when this Goodwill's listed on it and
companies could be acquiring other
companies for just ridiculous premiums
and there's no way of really keeping
track of that and so that's what I'm
going to try to accomplish at this point
since there's accounting rules have
changed and goodwill doesn't have to be
amortized anymore how do you proper
value that okay so let's turn to our
friend Buffett here and see what his
opinion is on goodwill so his opinion of
accounting goodwill which I just
described is that it's nothing more than
a number that's listed on the balance
sheet
he doesn't really place much value in
what you see on the balance sheet as far
as that number that's listed under the
goodwill and he definitely didn't place
a lot of value prior to 2001 when you
were having to amortize that amount so
when he likes to distinguish is between
accounting goodwill and economic
goodwill and so here's his definition of
economic goodwill businesses logically
are worth 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 return is
economic goodwill okay so I know that
might be a little bit confusing because
he's very concise with his words and he
has it all compact into that into that
quote but what I'm gonna do is explain
that to you okay so what is economic
goodwill so the first term that he
throws out there as net tangible assets
now I briefly described that earlier
your net tangible assets go to the
bottom line of your balance sheet and
look at the equity okay whatever that
number is
you're gonna then subtract out the
intangibles which is your the the line
that says intangibles and goodwill
you're going to subtract both of those
from the equity okay and then you're
gonna subtract out any of the par value
of the preferred stock so most companies
don't have the preferred stock so all
you're gonna do is you're gonna look at
the equity and subtract out the goodwill
and the intangibles and that's your net
tangible assets okay so that's the magic
number that he's really looking at
whenever he's assessing that baseline
Book value of a company okay that's the
number so when we were looking at our
two companies earlier with these generic
scenarios we had apple with an equity of
a hundred thousand and a net income of
40-thousand and if you remember there
was no intangibles on their balance
sheet at the beginning of that scenario
so our return on equity and our return
on net tangible assets was exactly the
same at forty percent and the same thing
as you look over there to the best app
that when he was 20 in that camp net
income was 10 and so are our OE and our
return on net tangible assets was
exactly the same at 50% now you're not
gonna commonly see that because most
companies have intangibles listed on
their balance sheet let's figure this
out for a company that has net tangible
assets so the second scenario after
these two companies had merged we had
$30,000 of goodwill listed on the
balance sheet so we're just gonna say
that that's all of our intangibles is
that 30,000 a goodwill so when we do the
return on equity scenario we go over
there we looked at our equity it's a
hundred and fifty thousand dollars and
our net income is fifty so we're gonna
take 50 divided by 150 in our return on
equity is thirty three percent
but what Buffett would do is he said
well let's look at the return on the net
tangible assets okay and so he would
take that $50,000 from net income and he
would divide it by a hundred and twenty
thousand instead of the hundred and
fifty and what he did is he subtracted
out the intangible when he does that you
can see that that's a 441 point six
percent return so why is that number
that net tangible assets important and
this is me kind of dissecting back that
original quote so why is that important
it's because Buffett believes that
economic goodwill is inflation-proof
whereas tangible assets are not okay so
when we looked at that last scenario
right here when we subtracted out that
$30,000 what he's doing is he's looking
at how much is it going to grow off the
tangible assets because that is not
inflation proof but the goodwill that
$30,000 of goodwill is inflation-proof
so what we're getting at here is that
Buffett's opinion is that having some
goodwill on the balance sheet isn't
necessarily a bad thing which goes
completely against you know Benjamin
Graham and I'll discuss that at the end
the difference between the two of them
but Buffett's opinion is that having a
little bit of goodwill on a balance
sheet isn't a bad thing because that
goodwill is inflation proof and what he
does is he demonstrates this and this is
pulled out of his his shareholder
letters from 1972 he gives a
demonstration of his opinion on goodwill
and how its inflation proof
and how he does that is he provides an
example and this is very similar to the
example he provides with a little bit of
difference but for the most part this is
exactly the scenario that he describes
in his shareholder letters so what he
does is he compares sees candy to a
boring Square company is what we're
gonna call it okay and what he says is
that the net income on seized candy when
he originally bought it back in the
early 1970s was two million dollars in
net income okay now his net tangible
assets for seized candy was eight
million dollars so you can see that his
return on the net tangible assets was
twenty five percent okay
now what he did is he compared this to
just a generic example of boring Square
company and he says let's have the same
profit the same net income of two
million dollars but let's say that their
net tangible assets are a lot higher and
let's just say it's 18 million dollars
okay so it's it's producing the same
profit but it's got a whole lot of
tangible assets sitting there producing
that that income so when we look at the
return on the net tangible like C's like
I said before it's 25% and then when we
look over at the BIC the boring Square
company it's only 11.1%
and when his argument is is that C's had
a lot of economic goodwill whereas the
boring Square company had little to no
economic goodwill so if we were going to
use interest rates at 11.1% and the
reason I use that is because that's
exactly what our return on our net
tangible assets would be for the boring
Square company okay
so let's assume that our interest rate
that we're comparing these two that
we're gonna discount it all back at is
11.1% that would put a market value on
C's at fifteen million dollars okay and
then at the market price on the boring
Square company is obviously going to be
eighteen million which is exactly where
their net tangible assets are at okay so
looking at this company you can see that
they both have the same profit margin
C's has less than 50% the net tangible
assets beget the value on both of these
companies are very similar at fifteen
and eighteen million so this is where he
really demonstrates his point let's
assume that inflation occurs right now
at a hundred percent okay so we went
from the last scenario to this scenario
okay and between those two scenarios we
have a hundred percent inflation okay
now when that occurs with seas can be
let's go over there and look at them
first if you remember the net income on
the previous slide was two million now
it's four million because we had a
hundred percent inflation occur and
since when that happens Buffett says not
only are you making double the net
income but which you have to do is you
have to double your net tangible assets
so before we were dealing with eight
million for our net tangible assets but
in order to produce that four million
think that that additional two million
and on our net income we had the double
our net tangible asset so when we when
we double our net tangible assets to
make that additional two million dollars
we have to invest eight million dollars
in order to make that additional two
million dollars okay now let's go over
and look at what happens with boring
Square company whenever we conduct a
hundred percent inflation as you look at
their net income it also doubled up to
four million dollars it used to be two
when we look at the net tangible assets
it went from 18 million to 36 million
okay just like C's where we had to
invest some money in order to make that
additional net income over here at
boring Square company we had to invest
18 million dollars in order to make the
same exact two million dollars that sees
candy made okay so this is where it
starts getting interesting and I'm sure
this can potentially get confusing at
this point so just stay with me I'm
almost done here the thing that I have
to look at here is what impact is does
the market price have after all that
fallout okay so after that inflation all
occurred and you know all those
adjustments are made how does the market
price look between these two companies
okay so when we still use that 11.1%
interest rate then we discount all that
money back okay we come up with a market
valuation on C's for twenty nine million
dollars we come up with a market
valuation for boring Square company at
30
six million dollars okay now if you look
then that tangible assets for boring
Square company is 36 and the market
value is still 36 when we look over at
C's the net tangible assets are only 16
million but the market value is almost
approaching 30 million so what does that
all mean okay so how is the one better
than the other so when we look at C's
candy we took eight we invested eight
million dollars and the resulted in six
million dollars in additional dollars
being produced in the market price due
to the economic goodwill okay and that's
what Buffett's getting at that
additional six million dollars was
produced in goodwill because it kept up
with inflation okay that goodwill kept
up with the inflation and it resulted in
an additional six million dollars in
market price but when we look over at
boring Square company they invested 18
million dollars in order to get that
same net income and it resulted in zero
additional dollars on the market price
okay on that nominal market price so
when you compare these two when we look
at the nominal growth that occur between
C's candy and the boring Square company
C's made an additional six million
dollars during that inflationary period
we're boring Square company made a zero
nominal growth during that time frame
so a lot of that is very confusing it
can be very difficult to understand
especially when you're dealing with
assets that aren't even something that
you can put your hands on but this is
where we're getting into security
analysis so when we look over at the
left there's a picture of Benjamin
Graham and Benjamin Graham had the
opinion that if a company would end
operations the net tangible assets are
the only things that are left of the
company and therefore the difference
between that market price that you pay
and the book value that's in the company
is your margin of safety Benjamin Graham
always like to look at the company as if
it was gonna die tomorrow and that the
company wouldn't be living any longer
and that
you had to be sure that when that
company died if and when that company
died you were there ready to collect
whatever tangible assets that remain in
the business now in order to understand
that mindset we got to look at when
Benjamin Graham wrote security analysis
which was in the 1930s which was during
the Great Depression so that's probably
why he had that that mindset so his
student Warren Buffett who adopted
almost every single principle that
Graham came up with kind of embellished
on that idea and you know Buffett's
gonna agree with Graham that the
difference between the market price and
the book value is your margin of safety
but then there's a huge but here Warren
Buffett also believes that real economic
goodwill is inflation-proof and
therefore adds more value to a business
okay so you can see how Buffett has a
twist on what Graham has you know has
written in all of his books if you go
read you know security analysis or the
intelligent investor you're gonna get
Graham's approach of bowing the business
as if it was dead whereas Warren
Buffett's kind of taken a new approach
and he likes the value of the business
as if it's dead and what is it going to
be worth if it's alive so he's looking
at both aspects so here's my take on it
economic goodwill is great protection
against inflation if you plan on owning
your shares and definitely so if you're
that type of person who truly is buying
these assets just like Buffett and you
plan on owning them forever well then
you're probably going to see the fruits
of your labor in that economic goodwill
because you're going to experience
inflation during that time if you're not
owning those assets for a long period of
time none of this is gonna really take
effect this approach should only be
utilized when future earnings are really
strong and that the debt in that company
is minimal because if you're not doing
that you're not going to be protected by
paying a premium well over those net
tangible assets so in the end it's my
opinion that a balance between
purchasing a company with some tangible
assets for safety and an appropriate
amount of goodwill is exercised so that
you can minimize your amount of
inflation
that you're experiencing so this is
really a balancing act that you're gonna
have to do this is something you're
gonna have to put a lot of thought into
I know this is kind of taking things to
a whole new level but this is how Warren
Buffett thinks and that's really what
we're trying to accomplish here at the
site and showing you some of these ideas
so this concludes course three unit six
lesson six what is goodwill