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Smart Investor: what is 'economic goodwill'?

In response to your queries, Smart Investor explains what he means by 'economic goodwill' and how it can help you assess a company.

 
Smart Investor: what is 'economic goodwill'?

Economic goodwill can help you get a more complete picture of return on equity, says Smart Investor.

A thank-you to my readers

May I begin by saying thank you for all your comments on my previous articles. I always read them and enjoy hearing your views, which I genuinely respect. Should you have any topics you would like me to write about, let me know – either in the comment box below, or via Facebook or Twitter – and I will do my best to incorporate them into future articles.

It was a recent comment that spurred this article. A couple of readers have asked about an expression I sometimes use: ‘economic goodwill’. So, this seems like a good opportunity to discuss what exactly it is and, moreover, why it is important for a company to have.

Accounting goodwill

Economic goodwill is not the same as accounting goodwill. Accounting goodwill arises from past acquisitions, where the buyer paid a price that exceeded the net asset value of the firm (net asset value being total assets less total liabilities). Accounting goodwill is designed to ascribe a value to assets such as employee/management ability, customer loyalty and reputation that do not appear on the balance sheet of the acquired firm.

Therefore, accounting goodwill is essentially hot air. Sure, it may represent the price paid for some intangible asset that previously did not have a monetary value placed on it, but it is only applied to acquisitions. For example, the ‘organic’ part of the company – meaning the part which was not purchased but which grew internally – does not have its employee and management ability, customer loyalty or reputation included as an asset on the balance sheet.

Accounting goodwill is a convenient way of accounting for any amount paid in excess of net asset value for an acquisition. In addition, it must be tested for impairment annually, with any impairments being reflected in the income statement, which can severely hurt the bottom line.

Buffet versus Graham

Economic goodwill is a rather more interesting topic. It is an idea that Warren Buffett places great importance upon and is one of the few concepts that he and Benjamin Graham appeared to disagree upon.

The basic idea is that share prices react to earnings growth. If earnings go up over time, share prices tend to go up and vice versa. Economic goodwill is essentially a measure of how much capital a company needs to invest in net tangible assets in order to increase profit. The less capital it needs, the easier it will be for the company to increase profits, all other things being equal.

So, let’s take two companies: company A has net tangible assets of £100 million and generates a profit of £10 million, while company B also generates a profit of £10 million but uses just £50 million of net tangible assets to do this.

Some investors (let’s call them Grahamites) conclude that company A is worth more than company B because, while the two companies generate the same amount of profit, you would receive twice the amount of net tangible assets were you to purchase company A.

However, other investors (let’s call them Buffetites) say the opposite. They argue that since company B requires half as many net tangible assets as company A to generate the same amount of profit, it is worth more. They claim that company B will require far less future investment in net tangible assets than company A would to deliver the same growth in profit, assuming all other things are equal.

Putting the theory into practice

Of course, the theory above needs to be put into some perspective. First, all things are not equal, and there is more to generating profit growth than just increasing net tangible assets. A company may not be able to maintain its current rate of return on net tangible assets in future and may require a greater relative amount of net tangible assets to grow profits than in the past.

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8 comments so far. Why not have your say?

Daye Tucker

Nov 09, 2011 at 08:35

Are tangible assets not also able to maintain a false value, if for instance, commercial property value is calculated on rental value? The high street is full of over priced empty properties. Rather than reduce and get a genuine market value rent, they are un let in order not to reduce book property value which would impact on portfolio and investment product values.

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John @ UKValueInvestor.com

Nov 09, 2011 at 09:19

Hi SI, interesting article.

That's more or less what I call return on retained earnings. I'm more interested in what a company has done with fresh capital (retained earnings) than with existing capital (what's already on the balance sheet), although the ROE figure and return on retained earnings over say ten years are often similar.

I think in many ways the Graham approach that you mention (asset based, possibly net-net focussed) is as far from the 'wonderful business' Buffett approach as hi-tech, IPO growth investing.

However, Graham did suggest a more Buffett like approach for the typical - or defensive - investor.

For the typical person he often suggested just buying 20 to 30 big, leading companies that everyone knows.

Then he said (more or less) to make sure the company wasn't obviously in decline, had a long history of earnings growth and dividend payments, and that you weren't overpaying for it (which he measured in various ways, but often mentioned a ceiling of twenty times the average earnings of the last decade).

That's actually fairly Buffett-like, although of course Buffett took the 'quality' side of things much further.

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Maverick

Nov 09, 2011 at 13:18

Smart Investor - Thanks - now I understand.

Surely these's a fairly tenuous connection between a company's net asset value and its share price? If you buy a share you're not buying a slice of the company's assets, except in the hopefully rare situation that a company winds up - and then the creditors will get most if not all of the assets.

Where does market sentiment fit into all this? Some companies seem to be able to do no wrong (e.g. Weir Group), whereas others (e.g. Mothercare) used to do well but have now fallen from grace. Are we not in danger of applying too much logic to an inherently illogical phenomenon?

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Robert Court

Nov 10, 2011 at 09:05

Companies are probably like civilisations in that they don't last forever.

As an investor you need to decide if you wish to invest in a company that is still dynamic or at the stage where most of its products are 'cash cows'.

You want a steady income with an established company in the hope that it's not declining or you wish to take a risk in a company that's at an earlier stage of development and hasn't got total market dominance?

Growth and Income, Income and Growth - the eternal circle.

I want both income and growth and if I can get a good income and its more than I need to live on then I can reinvest and reinvest and grow and gain more income.

Let's assume you invest in a 'good' company that gives you a 'huge' 4% dividend on its market value and you believe in never selling a good company. The share increases in value on average by 5% per annum but you'll still only get 4% of the market value.

Compare this with investing at a greater risk and getting a return of 10% and reinvesting 50% of your income.

The 'safe' company never goes bust and you never sell.

The riskier investments lose you 10% of your income 10% of the time but the rermaining 90% grow on average 10% per annum.

With the safe companies each £1,000 invested would generate you an income over 5 years of £40 + £42 + £44.10 + £46.32 + £48.62 = £221.04

The riskier investments would (with 50% reinvested and 10% average net of any losses growth and 10% income 'lost') would leave you with:

£45 + £57.25 + £66.12 + £76.37 + £88.21 = £332.95

The safe company's shares would have grown to be worth £1,276.28 and the riskier 50% reinvested investment would be worth £1,852.43.

Nobody has a crystal ball, but taking risks and assuming a certain percentage failure rate AND reinvesting 50% of your higher income gives, in the above hypothetical example, both a growing income and more capital growth by taking some risks even with some losses.

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Fenchurch

Nov 13, 2011 at 08:16

SmartInvestor - an idea for an article :- Looking over balance sheets that contain a lot of short term debt interests me. I used to avoid it but think now that its just how the business runs itself , often for years. Usually its unpaid suppliers but I would like to understand it better. So something relating to short term debt / debt profiles would be of interest to me.

Regards & many thanks for your very readable articles.

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Fenchurch

Nov 13, 2011 at 08:31

SmartInvestor - another suggestion :- There are a plethora of investment ratios , management ratios , key figures , operating ratios , solvencies , liquidity ratios..... I believe that some are very meaningful for certain industries and not that helpful for others (or even unavailable). Sectors like banking and building are quite different but both have a PE ratio. Its probably an enormous topic but some thoughts on the simpler and more common sector differences would be much appreciated.

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Dennis .

May 16, 2012 at 09:32

The problem with a lot of these analyses is that balance sheets only tell what the management want to tell. I recall working for a very large company and the FD told me that they decided at the beginning of the year how much profit they will make and how much tax they will pay etc. As for smaller companies the owner may have a hidden agenda eg passing it on to his children etc.

As ever we only work with incomplete knowledge, for me "Economic Goodwill" is just a current client list.

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Anonymous 1 needed this 'off the record'

May 16, 2012 at 09:36

My brother was once interested in buying a small hotel, the first thing he discovered was that the accounts rarely tell the whole story. There were usually a set of "real" accounts which were verbal and talked about cash payments etc. Eventually he decided not to go ahead as he couldn't be sure what he was buying.

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