The dream of any investor is to accurately determine the current and future value of a company issuing purchased securities. This would simplify tasks like calculating returns, assessing risks, and most importantly, creating an investment portfolio optimal for the stated goals. Unfortunately, precise calculations are practically impossible at present. The problem is that a company’s value reflects not only tangible assets (land, buildings, equipment, working capital, etc.) but also intangible, including non-identifiable assets. One of the latter is goodwill.
From this article you will learn:
- Investors aim to accurately determine a company’s value, including both tangible and intangible assets, to optimize investment portfolios.
- Goodwill represents the intangible competitive advantages of a company, such as brand reputation and management efficiency, impacting its value and stock prices.
- Various methods, such as comparative, cost-based, and indicator-based approaches, are used to assess goodwill and its influence on a company’s market value.
Concept of Goodwill
Goodwill is an economic term that quantifies a company’s competitive advantages in monetary terms. Goodwill includes all those intangible factors that increase the company’s appeal to buyers/investors:
- Business reputation;
- Brand recognition;
- Customer orientation;
- Implementation of innovative solutions;
- Business management efficiency;
- Authority of top managers and ambassadors;
- Geographic location, etc.
From this perspective, goodwill is an asset through which an enterprise can (and does) generate super-profits. However, this asset is intangible and, in fact, cannot be identified and evaluated by direct methods.
Companies also have identifiable intangible assets, such as licenses and patents. These have a known value that is included in the company’s balance sheet. These assets are not included in goodwill.
At the same time, accounting and economics employ fairly simple methods for calculating goodwill. It is viewed as a premium to the company’s book value paid upon purchase. This understanding also extends to the purchase of securities issued by the company.
For example, an investor buys 1% of a company’s shares and pays $1 million for them. At the same time, the company’s book value is $50 million. It is easy to calculate that the investor’s share in this book value will be $500,000. The difference between the price paid for the shares and the book value is goodwill, which in this case is $500,000.
This accounting approach leads to a somewhat paradoxical conclusion: goodwill created within a company cannot be evaluated. It only appears during a transaction in which the entire company or part of its assets is bought or sold.
Goodwill and Stock Prices
Warren Buffett accurately described goodwill’s impact on securities: “If the business does well, the stock eventually follows.” Indeed, if a company puts significant effort into creating competitive advantages, such as enhancing its business reputation, investor interest in it will inevitably grow. As a result, demand for the company’s securities and their value will naturally increase.
Currently, this process has accelerated significantly and plays a crucial role in forming stock prices. In 2000, auditors Arthur Andersen conducted an interesting study. For 3500 U.S. companies, they analyzed the share of book value in the market value over 20 years. The analysis showed that this indicator was at 96% in 1977 and fell to 27% by 1997. According to other studies, by 2020, this share had decreased further to 16%.
These figures reflect investors’ assessments of the company’s current state and prospects, clearly showing a growth in goodwill. However, this context refers to internally generated goodwill. Since clear assessment mechanisms are not yet used, such an influence can only be considered as assumptions and intuition, which is not always acceptable for an investor seeking to earn.
On the other hand, “accounting” goodwill, which receives a precise monetary expression during purchase/sale or merger/acquisition deals, is reflected in financial statements and can be adjusted upward (e.g., when buying a brand) or downward (processes known as impairment and amortization).
This indicator can also influence stock prices, although not as straightforwardly. For instance:
- In January 2002, Time Warner announced a goodwill write-down of $54 billion. On the day of the write-down, the shares hardly reacted and even showed a slight increase. However, in the preceding six months, the stock had fallen by almost 37%.
- Due to increased demand for healthy lifestyle products, Kraft Heinz, one of the world’s largest food producers, reassessed its assets and brands (Kraft, Oscar Mayer). As a result, in the financial report for Q4 2018, $15.4 billion was written off for goodwill impairment, leading to a loss of $12.06 billion. On the report’s release day, February 21, 2019, the stock dropped by 20%. Warren Buffett, who owned 26% of the company’s shares, lost about $4.5 billion.
Goodwill impairment can be both real and manipulative by companies. Top management may take such steps to reduce net income indicators without actual losses (since goodwill is an intangible asset, losses are only on paper). This does not go unnoticed by regulators; for example, the SEC launched an investigation into Kraft Heinz.
Since goodwill plays an increasing role in the value of companies, investors will need to master new methods for its assessment beyond accounting reports. Today, many such methods have been developed, among the simplest and most effective are:
- Comparative. The assessment is made by comparing with a similarly sized company with equivalent asset value.
- Cost-based. The calculation is based on the company’s expenses for advertising campaigns, technology implementation, staff training, etc.
- Indicator-based. Indicators of the issuer’s business activity are considered.
- Additional profit. The assessment is made by comparing the prices of two similar products, one of which is more expensive due to brand advantages.