Sunday, 12 October 2014

Goodwill. Understand the "cost" of goodwill.

Goodwill is an accounting term that describes the dollars paid to buy a business over and above its book value.  Goodwill is a real number, but it tells us nothing about the future earning power of a business.

Berkshire owns some terrific businesses.  Many of them were purchased, however, at large premiums to net worth - point reflected in the good will item shown in its balance sheet.  In year 2008, its balance sheet reported a goodwill of US 16,515 millions.  The company earned an impressive 17.9% on average tangible net worth in 2008, but if goodwill was included, this reduced the earnings to 8.1%.

Buffett paid more for these businesses because he expects them to earn gobs of money in the future.  In this happy event, the goodwill number is not relevant.

However, if increased earnings don't materialize, the amount of goodwill will weigh on the earnings of a business.  How will this affect investor returns?

By including the amount paid for goodwill in the return calculation, Buffett clearly reports the "cost" of goodwill.

In 2008, Berkshire investors got a return of only 8.1% on their total net worth, including goodwill, compared to a return of 17.9% on tangible net worth, excluding goodwill.

Most large U.S. companies have large amounts of goodwill reported on their balance sheets.  This information is important to know.  If companies pay more for acquisitions than the future earnings these ventures produce, investors will be harmed.

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