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.”