Goodwill: A Financial Illusion

Goodwill is one of the stupidest things in the world of finance. It's pure make-believe. It's the bitcoin of balance sheets. You can't see it, use it, and no one seems to know exactly what it is, but trust us, it's there.

Yea, no thanks.

Whenever you see a sizeable chunk of goodwill on a balance sheet, your spider senses should activate. Do a quick assets test. Remove goodwill from the equity and see what's left. You might discover that big bottom line equity is nothing but hot air. A company with billions of dollars in assets at first glance, might just be sitting on a pile of debt

So, how is goodwill created you might ask?

It's simple.

If one business buys another, then the acquired assets show up on the buyer's balance sheet. This includes two types of assets.

l Tangible assets: Real estate, inventory, equipment, loans, vehicles, accounts receivable, cash etc.

l Intangible assets: Brand names, commercial licensing agreements, patents and trademarks. They aren't physical things, but we can identify and isolate them.

But it's not only assets. Liabilities are also inherited, including borrowings, lease liabilities, accounts payable etc.

Crucially, not all liabilities or assets are included in every deal. A deal might exclude cash on hand or long-term borrowings, which are then adjusted for in the price.

Often a sale happens at a price higher than the net equity value (assets minus debts) of the acquired business. And that’s where things get weird. The excess paid still has to show up on the balance sheet.

After all, they bought something.

It can't show up as equipment, loans, or accounts receivable. It's none of these. It can't show up in the broad category of intangible assets, because we cannot isolate specific things bought. Instead, it's turned into a magical new asset called goodwill.

Goodwill Creation in Action

Any large company with a penchant for takeovers, can offer a detailed example of goodwill creation in action.

Let's walk through a real life example.

Microsoft's 2023 Annual Report is packed full of goodwill creation fun. Take its purchase of Nuance Communications Inc for example. The $18.8 billion acquisition hit the balance sheet as follows:

Microsoft's acquisition of Nuance on balance sheet (Source: Microsoft 2023 Annual Report)

Nuance is an AI and cloud computing software provider. So it's no surprise to see the business is light on tangible assets.

Still to pay $18.8 billion for a business with $4.4 billion in gross assets and $2.4 billion in net assets does look a little bit extreme.

Welcome to the world of tech takeovers.

Who knows what Microsoft is really buying here?

It could be a few years head-start on AI chatbots, key customer or supplier relationships or a few key employees.

We don't get the strategic rationale for a takeover just by looking at the books.

Breaking it Down

The core of Nuance's business is their software, which shows up in the intangible assets category above. In fact, they break down the intangible assets allocation as follows:

Microsoft's acquisition of Nuance intangible assets (Source: Microsoft 2023 Annual Report)

Microsoft allocated $1.54 billion to technology-based assets, which includes Nuance's software. Software has a short lifespan in the fast-moving AI world, so Microsoft amortizes (depreciates) the value over five years, decreasing the asset value by 20% annually.

With the general intangible assets category, there are specific identifiable assets which we can value. For Nuance, this includes the software that the company has developed and its customer relationships.

An important distinction with goodwill is that it's non-specific. It's a catch-all category of intangible assets which aren't individually identified. It could include things like brand reputation, the loyalty of customers and how motivated employees are.

Because goodwill is not associated with anything specific, it can't be bought, sold or transferred out of a business. For this reason, tradeable intangible assets aren't included in goodwill. This includes things like patents, trademarks and mailing lists. Instead they fall under the broader category of intangible assets.

The Origins of Goodwill

So when did this illusion begin?

Surprisingly, goodwill has been around for centuries. Unlike Bitcoin, it’s both long lasting and performs a function.

As business takeovers create goodwill, it makes sense that the concept is tied to the rise of capitalism and corporations.

We accept the idea of intangible assets having value so much now that most of us don't even think about it. So much so that we now accept invisible and unusable currencies as having value. But if you went back a few hundred years, you'd have trouble arguing that an invisible asset called goodwill existed.

In fact, in human history terms, it's not that far back that the idea of a currency made out of paper would have been laughed at. After all, paper is not gold.

British Earl John Scott famously described goodwill as "the probability that the old customers will resort to the old place."

It sounds as much like a drunken rant than a deeply insightful reflection on the nature of economics. Scott's words while not very poetic, may be the best estimation of goodwill.

It's essentially the inertia of business. A business making money will continue making money unless it fails to maintain it's competitive advantage. Or something similar.

Hmm, maybe Scott was a wordsmith after all.

Goodwill can be found in the records of English contracts and accounts dating back to the 1400s. The legal definition as an accounting term dates to an English court in 1810.

From the late 1800s well into the 1900s it attracted more attention and discussion but remained a topic of controversy. In the latter part part of the 1900s goodwill was codified into various accounting standards and laws, which are refined over time.

Functions of Goodwill

If we are being cynical (why stop now?), then the main purpose of goodwill is to feed the hungry tax monster that every country has.

Hear me out.

If $1 billion is spent, and $1 billion of net assets is received, then the transaction is breakeven.

If a $1 billion acquisition only results in $700 million net assets, then a $300 million loss would immediately arise.

That would flow directly to the acquirer's profitability and reduce their tax bill.

By creating a magical new asset called goodwill worth $300 million, no loss occurs. Goodwill effectively balances the books on the transaction.

Taxation departments all around the world need to keep goodwill alive and breathing for the sake of their cash stacked coffers.

It’s a tax scam.

But, it’s also a charade.

If you're the board of Microsoft, happily buying up companies left and right, the last thing you want to do is explain to shareholders why you are destroying the balance sheet.

If every takeover ended in value destruction, shareholders might have questions.

And a board's first priority is always to keep their own job intact. So goodwill is a very useful mechanism for directors to save face.

Astute market watchers will still call them out on bad deals. But it all becomes harder to get the full picture with goodwill muddying the waters.

And all of that underwater, sandy floor murkiness is the perfect environment for an unscrupulous board of directors to spring a trap.

Just like a stingray hiding in the goodwill! (I’m not crazy, you’re crazy!).

There are plenty of exchange listed scam companies.

Gasp not in shock!

Some companies are run for the benefit of directors and management specifically at the cost of shareholders. They are run by incompetent and unscrupulous people who would feel no remorse in lifting your grandmas purse.

Frequent capital raises keep the busines afloat. Each deadline missed is excused with a reasonable explanation. Conveniently, every problem was not the board's fault.

Frequently, we'll see mergers and acquisitions of unlisted companies and other listed penny stocks. They always come with a good story, and more often than not a whole heap of goodwill.

The board looks like heroes, because they are making moves, buying business and expanding the company. But these badly planned and executed deals are the prelude to large goodwill writedowns in 2-3 years time as benefits fail to materialise.

We learn that a lot of hot air and another founder’s retirement plan was the sum of all that goodwill.

This brings us nicely to how goodwill is written off.

The Write-Off

Spoiler alert, it's never a reason to cheer.

Once per year a company must evaluate its goodwill. If the value of any businesses they have purchased falls below the "market value", then goodwill must be written down.

The problem is that writing down goodwill can be a career tactical decision.

We often see goodwill writedowns on a new CEO or Chairman taking over the reigns. This is passing off a heap of negative news to their predecessor. Bringing forward the pain.

The new leader can then start their new role with a clean slate with a low hurdle to bring improvement.

Final Thoughts

A balance sheet that grows every year on the back of goodwill is one to be very wary of. It can disappear in an instant. After all it was never there to begin with.

It's worth paying attention to goodwill creation in any takeover deal. It can help us understand the actual value that the purchaser is getting. A tech acquisition with a high goodwill component might make sense. Perhaps it's all first mover advantage and acquiring the right talent.

But, if you are looking at business that makes money off assets, real estate for example, a large chunk of goodwill should ring alarm bells. In fact, any goodwill at all might.

The best way to approach goodwill? Ignore it.

Since goodwill is created out of nowhere on an acquisition, it makes sense to simply exclude it from any appraisal of the balance sheet.

Don't try to understand it.

Understand the business itself and its potential. Then frame that against the REAL balance sheet, which excludes goodwill.

Successful investing demands clarity, and goodwill is one of the financial world’s greatest illusions.

So when you see goodwill, think of Frankenstein’s Monster. Something unholy, deceptive and reeking of the rotting flesh of dismembered corpses.