Economic Goodwill
I look to invest in exceptional businesses, my shorthand for those with economic Goodwill. There is an excellent discussion of economic Goodwill (and its difference from accounting Goodwill) in an appendix to the 1983 Berkshire Hathaway Letter, dryly titled “Goodwill and its Amortization: The Rules and The Realities”. Judging by its style and wry humour, my guess is that it was written by Charlie, not Warren. On the surface, the appendix explains the impact on Berkshire’s intrinsic value of the USD52m accounting Goodwill created by the merger that year between Berkshire and Blue Chip Stamps, through which Berkshire acquired the 40% of See’s Candies and The Buffalo Evening News ‘owned’ by Blue Chip’s minority shareholders. Charlie however goes a step further and also makes the case for paying a seemingly premium price for businesses with economic Goodwill.
To refresh your memories, accounting goodwill is created when the purchase price of a business or asset exceeds its recorded carrying value. For example, when Blue Chip first acquired See’s Candies, it paid USD25m for a business earning USD2m on USD8m of net tangible assets (equal to a 25% return). This resulted in the creation of USD17m of accounting Goodwill (USD25m minus USD8m). Why would a rational buyer pay such a premium? The answer is for the economic Goodwill not on the balance sheet. Charlie elaborates:
…businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.
In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.
Under US GAAP, accounting Goodwill is amortised over time (up to a maximum of 40 years), creating a non-tax deductible charge against earnings and reducing the carrying value of the assets purchased back to their original recorded cost. This charge, Charlie explains, should be ignored when evaluating a business like Berkshire because it a) understates true earnings on the income statement; and b) understates the true value of economic Goodwill on the balance sheet. Why is the amortisation of accounting Goodwill not a true economic cost? In the case of See’s Candies, Charlie argues:
But what are the economic realities? One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition of See’s were not true economic costs. We know that because See’s last year [1983] earned $13 million after taxes on about $20 million of net tangible assets – a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill increased in irregular but very substantial fashion.
Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.
That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation.
It’s strange how we’d account for Goodwill this way but Charlie is honest enough to say he doesn’t have a better solution. So instead of using reported earnings to assess and value a business, he suggests the following:
“What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortisation of Goodwill, is the best guide to the economic attractiveness of the operation.”
Charlie illustrates with a numerical example, comparing the effects of inflation on a business with economic Goodwill and one without. His analysis boils down to the former requiring less additional capital to maintain its earning power, simply because it does not have to pay to recreate its economic Goodwill (the source of its earning power). Getting the same earnings for less capital therefore implies a higher return on re-investment. See’s Candies might have to put more money in for receivables and inventory but it won’t need to pay again for its customers’ loyalty. And while you might have to pay more for such a business, ceteris parabus, you will be rewarded by a higher market value for each dollar re-invested because of the high return it can earn. Charlie has seen this in his experience, where:
…a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.
And in contrast:
Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
This was a firm rebuttal of the conventional wisdom of the time (and still today?) which held that the best hedge against inflation came from asset-heavy businesses with natural resources, plant and machinery, and other tangible assets. Charlie also points out that there are situations where accounting Goodwill actually overstates economic Goodwill, and so might be better re-labelled “No-Will”. In these cases, all that is on the balance sheet is the capitalised value of management’s adrenalin - the silly premium paid in a moment of overexcitement.
A friend argues that the premium we pay over net tangible assets is precisely for the right to a high return on future re-investment and growth. The diagram below summarises Professor Bruce Greenwald’s framework for Earnings Power Value (Total Value = Asset Value + Earnings Power Value + Growth Value) and gave me another way to think about economic Goodwill. Per Charlie and my friend’s thinking, we don’t even have to begin extrapolating or making forecasts to know that growth of any kind at a high rate of return will be worth more than at a low rate of return.
Of course, the challenge with economic Goodwill is figuring out how much to pay for it. Ben Graham’s style of value investing ignored economic Goodwill and looked only at a company’s potential liquidatin value (i.e. the value which could be immediately realised from its tangible assets). Valuation could be told in an instant from the balance sheet. Charlie’s approach however looks entirely at the future. And as they say, it’s difficult to make predictions, especially about the future!