Goodwill to all persons
If you are thinking it is a little early to be talking about Christmas, then you are clearly not in the retail trade!
But Lo, I bring tidings of great joy! Today I will talking about balance sheets and particularly of course goodwill.
The accounting angle.
It is tempting to think of goodwill as simply some tomfoolery of double-entry booking keeping.
Goodwill arises when a company makes an acquisition and they pay more than the asset value acquired. To make the balance sheet, well, balance, those tricky double-entry bookkeepers insist that we create a notional asset called goodwill to cover the difference.
Total poppycock, isn’t it?
The layman’s angle.
Even before taking an interest in company accounting, I had an understanding of goodwill which is best described by example.
If I were negotiating to buy a window cleaning business, I might consider the value of the assets as a £2,000 van plus various buckets, cloths, ladders and detergents worth £500. In the course of negotiations I might be prepared to pay an extra £7,500 for the customer lists (the customer goodwill) and therefore pay £10,000 in total.
At first, this seems different to the accounting way of things. The ‘goodwill’ is a real (if intangible) thing on which I have explicitly placed a value, not some accountants trickery.
Of course you are probably ahead of me here in realising that the two are totally equivalent. Our aspirant window cleaner has made exactly the same judgement as an acquiring plc on what to spend on their acquisition.
So goodwill is real then?
To a degree I would argue that it is. When investing in a company you are inherently trusting the judgements of its Directors and this goodwill is a representation of their judgement of what the acquired business is worth over and above its fixtures and fittings. That valuation being based on the ability to generate ongoing profits in the future.
However, the oddity is that prior to being acquired, the window cleaning business had a balance sheet asset value of only £2,500, but once acquired its net asset value is £10,000.
We have ‘created’ £7,500 of value simply by buying it! We could have created even more value by over-paying. Hold that thought – I will come back to it.
Some proper double-entry wizardry.
My musings on this subject were prompted by a recent discussion about the AA [Ticker : AA.]
The AA has a Net Asset Value [NAV] of minus £1.70Bn (leave alone the Tangible Net Asset Value [TNAV] of minus £3.0Bn)
At the timing of writing it has a market cap of £0.37Bn.
But supposing I set-up a NewCo, injected £0.37Bn into it and used that to purchase the entire share capital of AA (at no premium).
NewCo now has a positive NAV of £0.37bn comprised of minus £1.70Bn of negative AA NAV plus £2.07Bn of newly created goodwill (total intangibles therefore of £3.07Bn.)
Wow! I was impressed by how much value we created in our window cleaning business, but this would be truly awesome.
Of course I am just playing tricks with the numbers and this parody probably epitomises why many investors only look at TNAV, not NAV.
But is the illusion truth?
This musing prompted a further thought. Investors buying shares in the AA at the current price (and remember the current price represents the equilibrium between buyers and sellers) are implicitly making exactly the same transaction as my NewCo (but for part rather than all of the business).
So they are effectively ‘creating’ substantial goodwill on their personal balance sheet.
Investors are implicitly making an assessment that the value of the AA’s future profits are worth paying well over the current book value of its assets.
My ‘ridiculous’ NewCo is in fact just crystallising the ‘goodwill’ that the market and AA investors implicitly recognise.
I have no particular view on whether investors in the AA are right or wrong (I can say though that it is not even on my watchlist). I do though very much believe that there are businesses which effectively have ‘goodwill’ that is not recognised on the balance sheet.
Unrecognised Goodwill that I do believe in.
Just to provide one example Tate & Lyle [TATE] a company I have owned in the past and may well do so in the future. It has the following characteristics :
TNAV : £1.15Bn
NAV : £1.49Bn
Market Cap : £3.44Bn
This company trades at a 130% premium to NAV and a 199% premium to TNAV.
So in other words in addition to the £0.34Bn of intangibles actually recognised on the balance sheet, the current share price implies a further £1.95Bn of “goodwill”.
I do not for one moment think that Tate is a bargain at the current share price, I would probably argue that it is ‘about right’.
Back in March 2018 the share-price was 25% below the current level. I missed it at the time but with hindsight that was creeping into bargain territory, but that was still a 100% premium to NAV at the time (£1.29Bn of implicit non-balance sheet Goodwill)
Being a ‘sugar producer’ is hardly fashionable, you might even say deserving of secular decline. Nevertheless my view is that Tate’s brand and customer relationship is deserving of a substantial slug of ‘goodwill’. The only way for that to be recognised on the balance sheet, would be for someone to acquire them and even then, the most stringent value investors would discount the goodwill.
The share-price would have to decline more than 50% to pass the bargain balance sheet threshold of P/NAV <1. Unless something drastically negative happens that would be madness incarnate.
With my “NewCo” example above I think I justified why some valuation based investors ignore Book Value and only look at Tangible Book Value. As my example of Tate & Lyle hopefully illustrates I take a different stance. My problem with “Goodwill” (and in fact intangibles in general) is not just that the intangibles can be grossly overstated but also that they can be grossly understated.
So whilst some investors take no interest in NAV favouring instead TNAV, personally I take little interest in either.
I should caveat that, to exclude investments that are pure “asset plays”, where clearly asset values are important (although those asset values may still be different than those shown on the balance sheet).
For a supposed “value investor” I often have a disturbing disregard for the balance sheet or at least for some of the conventional ways to look at balance sheets.
If you have been enthralled by what I have covered here, then I would suggest (other than that you seek some sort of therapy!) looking out for my further musings on balance sheets over the coming weeks.
In the meantime, I should just balance my views with the fact that despite my misgivings there is plenty of academic evidence out there that on average companies with low P/NAV ratios outperform those with higher values. I would caution though that I believe this to be quite sector specific and have a hunch that for some sectors at least the impact of tangible assets is waning.
As is always the case with my writings, I offer this up as food for thought only, not advice, and comments/questions/dis-agreements are always welcome.