Warren Buffett on Economic Goodwill (Intangible asset)

WARREN BUFFETT ON ECONOMIC GOODWILL

This is what Warren Buffett calls economic good will which he explained in 1983 like this:

‘[B]usinesses 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.’

Using by analogy, one of the favorite examples of Warren Buffett, take two separate companies. Company A has a net worth of $100,000, $40,000 of which is net tangible assets and $60,000 of which is intangible (brand name, goodwill, patents etc). Company B has the same net worth but $90,000 its assets are tangible. Each company earns $10,000 a year.

• So Company A is earning $10,000 from tangible assets of $40,000 and Company B is earning $10,000 from tangible assets of $90,000.

If both companies wanted to double earnings, they might have to double their investment in tangible assets. 

• For Company A to do this, it would have to spend $40,000 to add $10,000 of earnings. 
• For Company B to do this, it would have to spend another $90,000 to add $10,000 to earnings. 

All other things being equal, Company A would have better future prospects of increase in real earnings than Company B.

THE REAL PROFITABILITY OF A COMPANY

For these reasons, Warren Buffett has said that, in calculating the real profitability of a company, there should be no amortisation of economic goodwill. Does the Gillette brand name actually decrease in value each year? Of course not.

The thoughts of both Graham and Warren Buffett are worth consideration. Book value is another ingredient in the investment equation.

Benjamin Graham and Warren Buffett appear to have differences in importance on tangible and intangible assets.

The assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

WHAT BENJAMIN GRAHAM SAID ABOUT INTANGIBLE ASSETS

‘Earnings based on these intangibles [eg goodwill] may be even less vulnerable to competition than those which require only a cash investment in productive facilities.

'Furthermore, when conditions are favorable, the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth.

Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.’ Emphasis added.

HOW WARREN BUFFETT LOOKS AT INTANGIBLE ASSETS

This last comment of Graham has importance for Warren Buffett, who seems to really like companies with valuable, and sometimes irreplaceable, goodwill. 

To Warren Buffett, it is this intangible good will, an asset that continually produces profits without the need to spend money on maintenance, upgrading or replacement, that adds value to a company. 

Consider what it is that is most important in producing profits for Coca Cola: its name and recipe, or the various factories that produce the drink.

http://www.buffettsecrets.com/book-value.htm

THE BENJAMIN GRAHAM APPROACH TO BOOK VALUE

Graham clearly considered book value an important factor in assessing share investment. He did not include intangibles in his calculations of book value and was attracted towards companies that sold at below their book value. 

This was a big factor in making a judgment about the company as an investment. He said this:

‘It is an almost unbelievable fact that Wall Street never asks, "How much is the business selling for?". Yet this should be the first question in considering a stock purchase.

'If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking. The rest of his calculation would turn about whether the business was a "good buy" at $200,000.’

Graham did however acknowledge that under ‘modern conditions’ intangibles were just as much an asset as tangibles, assuming of course that a proper value could be determined. They could, in some situations, even be superior assets.

WHAT IS BOOK VALUE?

WHAT IS BOOK VALUE?

The book value of a company is generally considered its net worth; the book value per share would be the net worth of a company divided by the number of shares outstanding.

BENJAMIN GRAHAM DEFINITIONS

There is a need, in considering the book value of a company share, to know what certain terms mean - and who better to explain them than the doyen of investment analysis, Benjamin Graham. His definitions are:

Tangible assets: Assets either physical or financial in character eg plant, inventory, cash, receivables, investments.

Intangible assets: Assets which are neither physical nor financial in character. Include patents, trademarks, copyrights, franchises, good will, leaseholds and such deferred charges as unamortised bond discount.

Graham took the view in Security Analysis that intangible assets should not be taken into account when calculating book value; hence, in this sense, book value per share would be the same as net tangible assets per share (NTA) as opposed to net assets per share (NA).

So, the assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

Value Investing is a time tested investment strategy that works in most market environments.

Value investing is finding a good quality stock that you are proud to own for an inexpensive or bargain price.

Basically, a value stock has a low price to book value and a low price to earnings ratio. In determining whether a stock is inexpensive or not, one needs to analyze the company’s book value, also known as shareholders’ equity. You need to determine what the true net worth of a company is by calculating a tangible book value.

It’s critical to pick a company with an excellent management team.

http://myinvestingnotes.blogspot.com/2010/07/characteristics-of-value-stocks_23.html

Business Valuations versus Stock-Market Valuations

The impact of market fluctuations upon the investor's true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses.

The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice.

(1) As a minority shareholder or silent partner in a private business.

Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets.

He would usually determine the value of such a private business interest by calculating his share of the net worth as shown in the most recent balance sheet.

(2) As a common-stock investor.

He holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment - when the market is open, that is - and often is far removed from the balance sheet value.

(Stocks now exist, for the most part, in purely electronic form and thus have become even easier to trade than they were in Graham's day).

The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner.

The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or "balance sheet value"). [# Book Value (Net Asset Value) ]

In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.



A factor of prime importance in present-day investing.

The whole structure of stock-market quotations contains a built-in contradiction.

The better a company's record and prospects, the less relationship the price of its shares will have to their book value.

But the greater the premium above book value, the less certain the basis of determining its intrinsic value - i.e , the more this "value" will depend on the changing moods and measurements of the stock market.

Thus, we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares.

This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be - at least as compared with the unspectacular middle-grade issues.

(What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)

The argument made above should explain the often erratic price behaviour of our most successful and impressive enterprises.

For example
- IBM (International Business Machines).
The price of its shares fell from 607 to 300 in seven months in 1962-63; after two splits its price fell from 387 to 219 in 1970.
-Xerox - an even more impressive earnings gainer in recent decades - fell from 171 to 87 in 1962-63, and from 116 to 65 in 1970.

These striking losses did not indicate any doubt about the future long term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.



The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks.

If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value - say, at not more than 1/3 (one-third) above that figure.

Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and as having a justification or support independent of the fluctuating market prices.

The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it.




A caution.

A stock does not become a sound investment merely because it can be bought at close to its asset value.

The investor should demand, in addition,
1. a satisfactory ratio of earnings to price (PE),
2. a sufficiently strong financial position, and
3. the prospect that its earnings will at least be maintained over the years.

This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions.

Once the investor is willing to forego brilliant prospects - i.e., better than average expected growth - he will have no difficulty in finding a wide selection of issues meeting these criteria.

(In the present market situation, may stocks meet this asset-value criterion. Many sell below their tangible-asset value. Many are now available at prices reasonably close to their asset values.)

The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.

As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market.

More than that, at times he can use these vagaries to play the master game of buying low and selling high.


Ref: Intelligent Investor by Benjamin Graham