Date Published: 7/5/2012

Hyllandresearch.com

When Evaluating a Companys Value Beware of Goodwill

As Microsoft just proved never put too much emphasis on intangible assets, such as goodwill when evaluating a companys balance sheet. This week Microsoft announced it will be taking a $6.2 Billion write down on its goodwill for its online business. This write down is projected to wipe out the companies fourth quarter profits for this year, according to the wall street journal. What exactly is goodwill? Investors can locate it by looking at the assets on the companys balance sheet. In Microsofts latest 10-Q filing with the SEC (found here: http://sec.gov/Archives/edgar/data/789019/000119312512170665/d313493d10q.htm)

Here, Microsoft has put a value of nearly $20 billion on its goodwill, which after the $6.2 billion write down released this week, will be reported around $13.8 billion. What are these goodwill assets, and how are they valued?

In his book Interpretation of Financial Statements Benjamin Graham defines goodwill as: (An) intangible asset purporting to reflect the capitalization of excess future profits expected to accrue as a result of some special intangible advantage held, such as brand names, reputation, or strategic location. He then goes on to add: In practice, the amount which goodwill is carried on the balance sheet is rarely an accurate measure of its true value. Being an intangible asset, it has no definite value. It is nothing you can put your hands on, nothing you can physically measure. Besides goodwill, other examples of intangible assets are patents, trademarks and leaseholds (estimated future income from an asset). Investors need to be very careful when including intangible assets such as goodwill into their calculations of a companys book value (In its most basic form Total Assets Total Liabilities) or estimates for future earnings. If anything is clear after reading our articles so far on Hylland Market Research, I want this to be it; putting any faith in estimates of the future, be it projected future earnings or projected increase of value, is illogical. By basing the calculation of a companys book value on intangible assets, an investor is putting his faith into the companys accountants and executives to place an accurate, unbiased estimate on those intangible assets value, and their projected value and earning potential in the future. We have seen these estimates time and time again be a leading cause for investor losses. Investors pay huge premiums for expected future growth (for example, as cited in our article Intelligent Investing Means Not Buying the Facebook IPO, found here) or future earnings, only to be disappointed when things do not turn out as well as anticipated. Think of the tech bubble, where investors bought stocks like pets.com because of projected future earnings of its users. Of course, the actual earnings from those users were almost nothing (in fact, it lost money on many of its sales!), but people assumed they might be able make money some day in the future and bought the stock hand over fist. Of course reality eventually settled in, and investors lost nearly everything, $300 million in the case of pets.com, because of their incorrect assumptions. By a company writing down an asset, they are assigning a new value to that asset. For example, if Microsoft values the brand name Microsoft being worth $5 billion, and later decide that the name is not as valuable as previously determined, Microsoft may write down that asset. Doing this affects the balance sheet (in terms of the reported value of the asset) and the income statement (in terms of earnings) of the company for the period. The affect on the companys income statement is a reduction in the earnings of the company during that period. In this case, if Microsoft generates approximately $6.5 billion in profit this quarter. After writing down $6.5 billion, it effectively takes a loss on that $6.5 billion, leaving it with no reportable earnings.

This will affect any evaluation metrics that investors use that deal with earnings, like EPS (earnings per share) or PE (price/earnings). Writing down also affects the balance sheet of the company, by reducing the value of its assets. This is significant for one of the basic fundamental calculations of a company, its book value. While researching a stock, a common check is seeing how it trades relative to its book value. That is comparing the companys market cap vs. book value where: Number of Shares Outstanding * Share Price = Market Cap Total Assets Total Liabilities = Book Value (All of these numbers can be found by reading the companys 10-Q (quarterly reports) or 10-K report (annual report) which is required by the SEC if the stock is listed on an exchange. The SEC has all company reports available online in a searchable database here: http://sec.gov/edgar/searchedgar/companysearch.html , or the company will make the reports available on their website, under the investor relations section.) Book value represents what the company would be worth if it sold off all its assets. A stock trading under its book value can be a sign as investors being overly pessimistic on a stock, and a good buying opportunity. Of course, it is not a sole reason to buy a stock. Be sure to be very cautious using any intangible assets as part of the calculation for Total Assets or estimates for future profits because as we have just seen, things like goodwill can change very rapidly. There may have been a sign of this write down coming. Of course with 20/20 hindsight vision it appears more obvious, but hopefully investors can use this as a lesson and apply it in the future for their investments. By gathering data from Microsofts previous 10-Q reports, we can see how Microsofts goodwill has changed over time.
Year 3/31/2012 6/30/2011 6/30/2010 6/30/2009 6/30/2008 6/30/2007 6/30/2006 6/30/2005 6/30/2004 Goodwill 19,698 12,581 12,394 12,503 12,108 4,760 3,886 3,039 3,115 EPS $2.68* $2.69 $2.10 $1.62 $1.87 $1.42 $1.20 $1.12 $0.75 Stock Price $32.26 $24.30 $25.81 $23.35 $27.63 $29.47 $23.30 $25.04 $28.49

= current estimates

The write down is primarily associated with an acquisition Microsoft made in 2007 of aQuantive, which was a $6.3 billion all cash purchase by Microsoft. This is evident in the nearly 300% jump in goodwill Microsoft reported between 2007 and 2008. Microsoft believed that these assets of aQuantive would eventually be worth what they paid, and/or generate some sort of profit in the future, so they were reported under goodwill on the companys balance sheet. Anytime a company reports a sudden large jump in any intangible asset, such as goodwill, investors should be cautious as more than likely, things do not pan out as optimistically as executives hope and they will have to be written down some time in the future.

Hylland Market Research is not responsible for loss of capital due to your investments. Investing involves substantial risks. At the time of writing, the author held no positions in stocks mentioned in the article.