The next lesson that Buffett teaches us in his book, ‘The Essays of Warren Buffett,’ is the difference between economic goodwill and accounting goodwill. You might vaguely remember these terms from a previous accounting class or maybe they’re brand new concepts to you, but either way, let’s first define them so that we can all operate under the same definitions for this post!
Economic goodwill is the subjective value of the intangible advantages a company has over its competitors such as an excellent reputation, strategic location, business connections and represented in its higher market value (over book value) if the company were sold.
An example that Buffett goes into is that in 1972, a company called Blue Chip Stamps bought See’s for $25 million. The company only had $8 million in tangible net assets, so the $17 million variance was recorded as a goodwill charge and was charged to the company in an annual charge of $425,000 to Blue Chip Stamps for 40 years to amortize it ($425,000*40 years = $17 million).
Now, since Berkshire Hathaway owned 60% of Blue Chip Stamps, that meant that they theoretically also owned 60% of See’s. So, Berkshire was also paying those amortization amounts but at 60%, so they owed $10.2 million over the 40-year period, but that meant that they also were being charge 60% of the $425,000, so an annual charge of $255,000.
11 years later, after Berkshire had paid down about $2.8 million, meaning they still owed ~ $7.4 million, they purchased the remaining 40% of See’s.
Berkshire paid $51.7 million over the net identifiable assets so they were assigned economic goodwill of $28.4 million, resulting in an amortization charge of $1 million for the next 28 years and then $700,000 for the 28 years after that.
In summary, because of the timing of this, the assets of See’s were valued very differently and were now on a completely different amortization timeframe and on a different value.
The frustration on the part of Buffett is that while See’s last year earned $13 million in net income on $20 million of net tangible assets, the accounting goodwill continued to decrease annually but the economic goodwill increased.
Buffett really attributes this this to inflation, stating that “true economic Goodwill tends to rise in nominal value proportionally with inflation.”
For instance, think of it this way – if a business has $10 million in earnings on $100 million of net tangible assets while another business has $10 million in earnings on $50 million net tangible assets, which business do you think would have a greater chance of success in doubling their earnings?
Theoretically, they would both have to double their net tangible assets as well, so the first business would need to increase their net tangible assets from $100 million to $200 million while the other would need to go from $50 million to $100 million.
Buffett takes this a step further to relate it to our own personal investing journey and says to imagine the following example:
A company has $20/share of net worth and they make $5/share in earnings. If you were to purchase a share of the company at $100, does that then mean that you should mark your own account with having an $80 goodwill charge? I mean, you just bought a company at $80 over the net worth of the company, right?
So, should you amortize your purchase over 40 years like these companies do? $80 in goodwill/40-year amortization time period = $2/share on an annual basis. Therefore, your $5 in EPS just got shrank down to $3 EPS, agreed? Personally, I don’t know if I agree with this thought process, but it really does make you think.
At the end of the day, Buffett feels that investors should really focus on these two takeaways:
1 – “In analysis of operating results – that is, in evaluating the underlying economics of a business unit – amortization charges should be ignored.”
2 – “In evaluating the wisdom of business acquisitions, amortization charges should be ignored also.”
The main takeaway that I have from reading this chapter is that it is very possible for a company to have a decreasing accounting Goodwill, but an increasing economic Goodwill based off of how the company was performing. This is the case with See’s and also was the case with Geico when Berkshire Hathaway purchased them as well, and likely will be for many other companies going forward.
Buffett signs off on the chapter by giving a major warning that many CEOs will group depreciation and amortization together in the grouping but that they are very, very different. Depreciation is a very real expense as assets become older, worn down and will require significant investments going forward while amortization is simply the paying down of those assets.
I view it as buying a car – if you paid $10,000 in cash for a car then that car’s value is going to continuously depreciate and be worth less and less when you sell it in 5 years. While you paid cash, maybe you don’t want to show it on your monthly budget that you paid $10,000 in cash at one time, so you put $250 on your budget for the next 40 months. If you sold the car in two years, that asset might’ve depreciated down $3000 but the car has been amortized $6,000 per your accounting practices.
So, now you’re going to receive $7000 for the car but you technically still owe $4000 left on it per your amortization process, despite the car actually being completely paid for. The point is that while they’re grouped together oftentimes, they do not go hand in hand with one another.
Buffett ends the chapter by proposing the change to have the acquiring company record the purchase price of the stock at fair value and then leave it on the books without amortizing it. Then, if the economic goodwill was impaired, they would simply just write it down like other assets.
Buffett thinks that this would drastically change the way that acquisitions were completed in the future, and I don’t know about you, but I find it hard to disagree with the value investing GOAT.