Accounting vs Economic Goodwill

Great insight on accounting from Buffett's 1983 letter.

My last Sunday article was published a couple of months ago, after almost two years of weekly publishing. It made itself clear to me that increased levels of depth are required for improving one’s analytical capacity. And I found that Sunday articles were starting to experience diminishing returns in this respect. At that point, I thought it would be wise to stop and think about what the steps forward should be.

I got to the realization that writing well thought ‘essays’ about how other disciplines may relate to investing was the best path. As a consequence of the time each of these takes, publishing would become infrequent. After some more consideration, I suspect it’s best to return to the prior format in the newsletter, while I work on these essays for a future date.

I have begun a long project of writing a book on these topics. It is my belief that highly profitable ground lies where almost no investor goes. Bringing insights from other disciplines after studying their roots is the objective of the book. Darwin, Smith, Freud, Jung, Newton, are some who I’ve already studied. I will also give an account of great ideas given by other eminent intellectuals, all of which can be leveraged for investing.

In any event, I returned to reading Warren Buffett’s shareholder letters. I had left them in 1984 and I’m trying to maintain a stable cadence to finish them. In Warren’s letters, I keep finding second-order insights on widely overlooked topics, most of which I don’t even understand myself. My intention is for Sunday articles to return to their original format, whereby I try sharing one of these things I come across. Publishing frequency will depend on how much I read in this territory.

Goodwill

When a company acquires another one, GAAP principles require them to record goodwill in its book. The goodwill equates to the difference between the price paid for the business and the fair value of the assets acquired, after subtracting liabilities. It’s the “excess of cost over equity in net assets acquired.” Once the acquisition effectuates, goodwill becomes an intangible asset that’s carried in the acquirer’s balance sheet. Thereafter, accounting principles make companies amortize the acquisition through the income statement until the goodwill is driven to 0.

Conceptually, a similar logic is utilized as when a business incurs capital expenditure to build a facility. The facility’s useful life is estimated and an amortization method is selected. The book value of the asset diminishes with time, as amortization charges are taken. Amortization tries to capture the inherent loss in value of the asset. However, it is here where accounting hits one of the many walls created by its limitations, revealed to me in Buffett’s 1983 letter.

See’s Candies

Blue Chip’s, wherein Berkshire had a large stake, acquired See’s Candies in 1972 for $25M, when See’s had $2M in earnings on $8M of net tangible assets. Given the difference between the price paid and fair value of See’s net tangible assets, Blue Chip’s recorded $17M in goodwill. Over the course of the following decade, Blue Chip’s took amortization charges every year, conceptually implying the useful life of the asset, See’s Candies, was running its course.

During the period 1972-83, the number of pounds See’s Candies sold increased by 45%, revenue grew 326%, profits 556%, and the network of stores kept growing at a very decent clip.

In 1983, See’s earned 13M dollars after taxes on $20M of net tangible assets. By any measure one would take, it’d be obvious that the company’s intrinsic value was increasing every year, with See’s competitive position improving. But accounting principles caused goodwill to decline in accordance with the predefined useful life of the asset.

That same year, Berkshire acquired the rest of Blue Chip’s. Part of their assets included $7.5M in goodwill remaining from their acquisition of See’s in 1972. However, Berkshire themselves paid $51.7M in excess of Blue Chip’s net assets, $28.4M of which were for See’s. Berkshire was therefore left with two different amortization charges, on different valuations for the same asset, purchased a decade apart.

Underlying fundamentals in businesses matter. The first lesson he draws is that a business’ value logically exceeds net tangible assets if the company can utilize them to earn returns in excess of market rates. Economic goodwill corresponds to the “capitalized value of this excess return.”

After accounting for this, Buffett posited that accounting goodwill misstates economic goodwill. The amortization charges Blue Chip’s took were only paper costs, but not true economic costs. A fair analysis would suggest that the price paid for See’s in 1972, with the respective accounting goodwill it implied, dramatically understated the economic goodwill of the franchise.

A second look reveals the disparity between both types of goodwill and the limitation of accounting. Firstly, even if the company’s goodwill disappears, it won’t happen in a linear fashion. Most likely, it will be abruptly, following the expiry of their competitive advantage period. Furthermore, Buffett explains that “true economic goodwill tends to rise in nominal value proportionally with inflation.” To understand how this works, Warren employs the following example.

See’s Candies was acquired for $25M, with $2M in earnings and $8M of net tangible assets. On the other hand, let’s imagine business A, which also has $2M in earnings but on $18M of net tangible assets. Very much likely, this business, which generated an11% return on net tangible assets, might have sold for the value of their assets, $18M.

In this case, it may seem that one would be paying $7M more for the same amount of profit and, in fact, less tangible assets. However, intangible assets can really affect the intrinsic value of a business. To a powerful franchise corresponds high levels of economic goodwill, which can be leveraged to earn excess returns for a long period of time. Furthermore, Warren anticipated a world of ongoing inflation, and this had severe implications on the type of business he’d rather buy.

Imagine prices in the economy double. To keep profits in real terms, companies would need to double their earnings. One would think it is as simple as selling the same number of things at double the price. Nonetheless, it is often missed that companies’ nominal investment in net tangible assets, including receivables and inventory, most likely need to rise alongside inflation. In this case, double the amount of investment would be required. Investments in fixed assets respond slower to inflation, but just as surely with time. It is crucial to observe that this increase in capital invested, which in the case of inventory and receivables is worse because they come before income from sales, produce no improvement in rate of returns.

In this scenario, if we remember both businesses, See’s Candies’ had $8M in net tangible assets, whereas business A had $18M. See’s would need to invest an additional $8M, bringing net tangible assets to $16M, to generate $4M in earnings. On the other hand, Business A would need to invest $18M, bringing net tangible assets to $36M, to generate $4M in earnings.

And there is one more thing. Not only See’s could double its earnings by investing much less, but the company also gains much more in market valuation. If valuations remain even, at 12.5 times earnings for See’s, and at 9 times earnings for Business A, See’s Candies, after the doubling in prices and investments, would be worth $50M. But business A would be valued at $36M. For each dollar See’s invested, it gained $3.125 in nominal value, whereas business A gained only 1 dollar in nominal value per dollar invested.