Applying the moniker "goodwill" to something that can be as crippling to a company's financial stability as a toxic debt instrument seems a little strange. A better name would be "mystery asset" -- because at least that way, unsophisticated investors would be less likely to skim over it on financial statements, thinking it's somehow tied to places where you donate old clothes to charity.
Goodwill writedowns have wreaked havoc on income statements and balance sheets across many sectors in multiple markets. Knowing more about goodwill can benefit all market participants -- and understanding their implications can prevent you from making mistakes with your own investments.
It's a mystery
Companies will often pay premiums when making acquisitions. The difference between a target firm's fair value and its price tag after acquisition costs ultimately becomes goodwill on the buyer's balance sheet.
An artificial asset, goodwill prevents an imbalance from being created on an acquiring firm's balance sheet that would normally arise after paying more for something than its actual value. Instead of having its liabilities exceed assets or impacting shareholder equity, a company can assign the premium to goodwill and balance its books.
Companies peg goodwill to various sources of expected future cash flows. Those sources can take on a number of forms -- even expected benefits from other types of intangible assets, such as patents and trademarks. If one or more of those sources loses its supposed earning power, however, the goodwill will often be deemed impaired, and the company will take a writedown on its value.
Take warning
So say your company acquires another company, and as part of the acquisition, it receives a number of patents, to which it pegs a portion of newly created goodwill. If those patents become obsolete, then the company typically writes down the goodwill at least to the extent it was pegged to the patents.
Companies are required to test goodwill for impairment at least once a year. Sophisticated accounting practices, however, can make it difficult for investors to figure out which company earnings and revenues are tied to the company's goodwill, and companies have no legal obligation to be fully transparent about such matters.
Perhaps the scariest thing about goodwill is how important a potentially worthless asset can be to the business. A company can borrow on imaginary assets that are susceptible to vanishing at a moment's notice -- and if it has debt covenants tied to its total assets, that can spell disaster.
Red flags
To avoid such problems, analysts sometimes look at the market value of a firm relative to its goodwill. If a company's market cap falls below its book value, that's sometimes a sign that goodwill should be written down.
Of course, some companies have zero goodwill, which implies zero risk of goodwill impairment charges. Among those are ExxonMobil (NYSE: XOM) and Occidental Petroleum . But many companies have reasonably small amounts of goodwill, such as the firms listed below:
The Good
Market Capitalization ($mm)
Goodwill ($mm)
Total Equity ($mm)
Goodwill % Market Cap
Goodwill % Total Equity
Apple
(Nasdaq: AAPL)
85,805
207
22,909
0%
1%
Altria Group
(NYSE: MO)
33,679
77
2,828
0%
3%
Home Depot
(NYSE: HD)
34,469
1,134
17,777
3%
6%
Source for all charts: Capital IQ, a division of Standard and Poor's. Market cap as of March 12.
If a company's goodwill alone exceeds its market capitalization, then that increases the odds of seeing impairments in the near future.
The Bad
Market Capitalization ($mm)
Goodwill ($mm)
Total Equity ($mm)
Goodwill % Market Cap
Goodwill % Total Equity
Ingersoll-Rand (NYSE: IR)
4,442
6,620
10,703
149%
62%
Tyco International
9,097
11,020
14,894
121%
74%
Johnson Controls
5,598 Continued... |