Economic Goodwill vs. Accounting Goodwill – A Treaty On The Competitive Advantages Of A Business by Anton F. Balint
Accountancy is a fascinating profession. It uses numbers to explain what a business is and does – at least in theory. The practice of financial reporting ought to give current and potential investors the necessary data about a particular business. In other words, it should be the bedrock of all investment decisions. However, on the balance sheet of most companies, two assets spread fear in the heart of conservative investors: intangibles, such as IP rights, and goodwill. While the former is arguably as hard to trace as the latter, there are methods, algorithms and an army of patent attorneys to help investors get a pretty clear understanding of the value of IP rights. On the other hand, goodwill is a different animal.
In a 1984 Berkshire Hathaway letter to shareholders, Warren Buffett wrote an appendix on goodwill. More specifically, he discussed the difference between accounting goodwill and economic goodwill. Very straightforward, accounting goodwill is the result of accounting principles and arises when a business is bought. The process is the following: Company A targets Company B as an attractive acquisition. Then Company A evaluates the fair value of the identifiable assets that it will acquire. Most often, however, the sum attributed as the fair value of the identifiable assets (after all liabilities have been taken out) is less than the purchase price of the business. That premium over the price paid for the identifiable assets is called “goodwill,” and it is assigned to the balance sheet as an asset. Sometimes accounting goodwill can be found under the extensive name of “Excess of Cost over Equity in Net Assets Acquired.”
Later we will examine in mathematical detail how this “asset” behaves and how cautious investors ought to treat it because, as Warren Buffet stated in the appendix, “except under rare circumstances, it [Goodwill] can remain an asset on the balance sheet as long as the business bought is retained.” In order to record the depreciation of this asset, amortization charges of an equal amount over not more than 40 years are recorded against the earnings account. Moreover, because such charges are not tax deductible, they have an effect on after-tax earnings. This is how accounting goodwill works. Now let us turn our attention to its sibling: economic goodwill.
Economic goodwill is the result of deeper forces that impact a business. It reflects the “moat” or competitive advantages of a particular business. To explain economic goodwill, we need a concrete example. Buffett’s initial example is the situation of See’s, which was bought by Blue Chip in early 1972 for $25 million at a time when See’s had only $8 million in net tangible assets. See’s had no debt, and it was earning a consistent $2 million net profit on the $8 million of assets — a consistent 25% return after tax on net tangible assets. It was a performance well above its peers and the market. As Mr. Buffett observed, what produced this amazing rate of return was not to be found in the premium over the fair value of the net tangible assets but in a cocktail of intangible assets, in particular, the company’s reputation. It was created on countless pleasant experiences that customers had with both the company’s product and personnel. These factors resulted in the business being able to earn the consistently high return on its net assets.
[drizzle]Coming back to the accounting process: Blue Chip paid a $17 million premium for See’s net assets and charged $425,000 to an income account annually for the next 40 years. In 1983, 11 years after the acquisition, the excess of cost over equity in net assets recorded by Blue Chip was reduced to around $12.5 million. At the same time, Berkshire Hathaway was owning 60% of Blue Chip and therefore, 60% of See’s. Berkshire’s balance sheet reflected 60% of the remaining $12.5 million (roughly $7.5 million). In 1983, Berkshire bought the rest of Blue Chip (the other 40%).The acquisition saw an accounting goodwill of $51.7 million, which included See’s premium of $28.4 million. The amortization charges were $1 million for 28 years and $0.7 million for the next 12 years. What Buffett observed was that different purchase dates and prices resulted in different values and amortization charges for the same asset. More importantly, in 1983, See’s recorded a net profit of $13 million on $20 million in net assets – a performance far above the initial cost of accounting goodwill. Therefore, while accounting goodwill decreases regularly with time, economic goodwill increases in an irregular but substantial manner.
Moreover, true economic goodwill tends to increase in nominal value proportionally with inflation. Why is that? Well, inflation tends to require businesses to raise their level of nominal investment in net tangible assets to keep up with rising prices. For example, let us assume we have a business earning $5 million after tax on $20 million in net tangible assets and another company that earns the same amount but on $30 million of such assets. In other words, the former produces a 25% return on net tangible assets after taxes, and the latter produces a 16.6% such return. The latter, therefore, might sell at a lower price than the first company. But why? How can less net assets dictate a larger price?
Well, this is the beauty of economic goodwill. The potion of qualitative factors that crystalize the economic goodwill ensures that the first company can produce continuously higher rates of return on its net tangible assets and therefore, the higher price is justified. Moreover, inflation erodes the return on net tangible assets, so the latter business operating on $30 million in net assets will require a larger nominal investment just to ensure the survival of the business, compared to the first corporation, which is able to operate on a lower base of assets. Therefore, you can think about economic goodwill as an invisible shield against inflation: just like the electromagnetic field protects our Earth from galactic radiation, economic goodwill (the “moat,” the competitive advantage) of a company will protect against inflation: a customer that enjoyed the product and the service of the business will continue to enjoy it even if it costs 2% more. People are more likely to pay a premium and accept the costs being passed on to them if the product is one that exceeds their expectations regularly and builds a psychological mechanism of confidence in what the company makes or serves.
Two important observations are needed to be made before illustrating economic goodwill with contemporary examples. Firstly, we notice a deviation from Benjamin Graham’s investment approach of “net nets.” Graham suggested that qualitative factors, such as the ability of the management team and the customer experience, should be left out of the business valuation and that we ought to focus more on the quantitative elements as they will render, in the long term, a more stable path to earn returns in excesses over the market. What Warren Buffett suggested to be the economic value is an approach adopted by the legendary Philip A. Phisher, which proved that qualitative factors are as important as quantitative matters. And as we will see below,