Goodwill: Plug Variable or Real Asset?

Of all the items on a conventional accounting balance sheet, none gives me more trouble than goodwill. It is not an insignificant item for some companies, amounting to a large percentage of overall assets, but it does not show up on the balance sheets of other companies. To anyone who encounters it, there are five questions that follow: What is it? Why it is there? What does it measure? Can it change over time? What do we do with it?

What is it?
While goodwill connotes something substantial, it is a plug variable. Note that it shows up on a balance sheet only when a company does an acquisition. Some accounting text books define it as the difference between the price paid for a target company and the fair value of its assets, but that would be a lie. Stripped to basics, goodwill is the difference between the market price paid for a target company and the book value of its assets, with a little fair value modification thrown in for good measure. Thus, if company A pays $ 10 billion for company B, and the book value of company B's assets is $ 4 billion, there will be goodwill of $ 6 billion on company A's balance sheet after the acquisition.

Why is it there?
The answer to that is very simple. Because balance sheets need to balance. There are two fundamental disconnects between market value and accounting book value:
a. Book value reflects historical cost (not current value): An acquisition lays bare one of the fundamental problems with an accounting balance sheet, which is that the values of assets (at least operating ones) are recorded at historical cost, rather than current value. An acquisition of another company is at current market value and has to be recorded as such by the acquiring company. If you cannot write up the values of the acquired company's assets to reflect the price paid, you will have to record the difference as goodwill.
b. Value of growth potential:  The fair value of a company reflects both the value of its existing assets and the expected value of future growth potential. The former is what is captured in accounting balance sheets but market value includes the latter. Thus, when an acquirer buys a target company, it will have to pay a premium on book value (which reflects the value only of existing assets), even if existing assets were fairly valued.
In effect, acquisitions create an inconsistency in accounting. While internal investments made by a firm get recorded at historical cost, acquisitions are recorded at market value. Goodwill then reflects the accounting attempt to make things whole again.

What does it measure?
So, what does goodwill measure? Building on the last part, the goodwill in an acquiring company's balance sheet is a composite of three inputs:
a. Misvaluation of existing assets: As we noted in the last section, if existing assets are misvalued, there will be goodwill even in the absence of growth. Consequently, the more existing assets are misvalued, the greater will be the goodwill.
b. Growth potential: Goodwill be larger, when you acquire a firm with greater growth potential, since the market value will reflect this growth potential but book value will not.
c. Overpayment by the acquirer: There is substantial evidence that acquirers over pay for target firms and this overpayment is attributed to multiple factors - managerial self interest and hubris, over confidence on the part of managers, and conflicts of interests. Whatever the reason, this overpayment, if it occurs, has only one place to go and that is goodwill.
This can be illustrated with a simple example. Assume that company A acquires company B for $ 1 billion and that the book value of company B is $350 million. Assume further that the fair value of company B's existing assets is $400 million and that the value of its growth potential is $ 500 million. If existing assets are not marked up to fair value, the goodwill of $650 million has three components:
the misvaluation of existing assets ($400 - $350), the value of growth assets ($500 million) and overpayment ($100 million).
Accounting changes over the last decade have been directed at addressing the first of these three - misvaluation of existing assets. Thus, appraisers, working under the tight constraints of both accounting standards and tax rules, are allowed to reassess the value of existing assets to better reflect their current value. In the example above, this would lead to existing assets being reassessed to $ 400 million and goodwill to $ 600 million. For the most part, there is little that accountants can do about growth potential, since those assets exist only in investor perceptions.

Can it change over time? 
 To the extent that goodwill is market-based, the value of goodwill will change from period to period. Thus, the value of existing assets and existing assets can change from year to year and the overpayment has to be recognized at some point in time. Until a decade ago in the US and still in most parts of the world, these reassessments of goodwill are put on auto pilot, with goodwill being amortized over 30 or 40 years, irrespective of the facts on the ground.
In the last decade, accountants have argued that the value of goodwill can be reassessed to reflect changes in the three components and the change should be reflected in earnings. While the amortization or impairment of goodwill tries to reflect this reassessment, there are three issues in how it is done:
a. Timing lag: To make their assessment of whether and how much to reassess goodwill, accountants look to markets. Thus, the goodwill accrued by Time Warner from the acquisition of AOL was impaired by $54 billion in 2002, but only because technology stocks had collapsed in the market in the previous two years.  Since everyone in the market already had made this adjustment, the actual impairment of goodwill was treated by the market as being of no consequence.
b. Unidirectional: Goodwill impairments almost always seem to lower the value of goodwill. If this were a fair reassessment, you should see a significant number of companies where the value of goodwill gets assessed upwards.
c. Composite adjustment: The impairment of goodwill is provided as one number, when it includes reassessments of existing asset values, growth potential and overpayment. Since the implications of each are different for valuation, it is one more reason why goodwill impairment is not a particularly useful piece of information.
In summary, goodwill impairment has become an earnings management tool for many companies rather than a test of fair value changes. In the process, it has lost its informational content and is of little help to investors.

What should we do with goodwill?

Here is the million or billion dollar question. Assume that you are valuing a company with a significant goodwill item on its balance sheet. How should it affect the way in which we value or view the firm?
a. Book capital and Earnings: The minute a company acquires another company, the characteristics of book equity and capital change. Rather than reflect just historical values (which is the case when a company has only internal investments), they incorporate market values for at least the target company's assets. Thus, book capital for an acquisitive firm includes the three components mentioned above for a target firm - a mark-to-market of existing assets, growth assets and overpayment. Since the rest of the acquiring firm's assets remain at their old values, the resulting book equity and capital is inconsistently defined. Earnings are also contaminated for a different reason. The impairment of goodwill can cause big swings in earnings from period to period. Since earnings and book capital are the key inputs into return on equity and return on invested capital (ROIC), the presence of goodwill can dramatically alter these returns.
To correct for goodwill, many  analysts adopt the policy of ignoring it all together in the computation. Thus, return on capital is measured as:
ROC = Earnings before goodwill amortization/ (Book value of capital - Goodwill)
However, I have a paper on measuring returns where I have argued that while it is perfectly reasonable to net out the first two components of goodwill - misvaluation of existing assets and growth potential- from book capital, overpayment should not be netted out. In effect, companies like Time Warner should not be allowed to wipe out their mistakes and return their capital to pre-mistake levels, since stockholders have paid the price for these mistakes. Of course, separating out what portion of the goodwill is for overpayment is tough to do, but we need to make an effort. (I propose that we call this stupid goodwill and contrast it with smart goodwill)
b. Valuation: In a discounted cash flow valuation, goodwill really has no direct effect, since we estimate the value from expected future cash flows. Those cash flows will reflect the true value of existing assets and growth potential. Thus, it is in incorrect to add goodwill on to a DCF value, since it double counts these values. If you are doing asset based valuation, where you try to estimate current market values for individual assets on the balance sheet, it becomes trickier, since goodwill is not a conventional asset. Here, there is no easy way out. You have to either take the accounting estimate of goodwill as a fair value or estimate the value of future growth (which would require a DCF). In relative valuation, goodwill does not really affect much if you are using operating income multiples (Operating income or EBITDA is pre-goodwill amortization anyway) but it can affect equity earnings multiples (PE ratio or PEG ratios), since those earnings per share can be affected by goodwill charges. Goodwill can become a problem with book value based multiples. In effect, if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.
One final thought. Given that goodwill, as an item, really changes nothing about the underlying assets and their value, no company should make or change decisions based upon the accounting measurement and treatment of goodwill. If you pay too much for a target company, what accountants do with or to goodwill cannot undo the damage already done.