When goodwill turns bad

published 29 April 2019

Management teams love doing big mergers and acquisitions deals.But investors should beware the hangovers that often follow.

Despite the jitters that hit global markets late last year, 2018 was a good deal for mergers and acquisitions (M&A). In total, $4.1trn-worth of deals were done last year, the third-highest sum ever, and second only to 2015 and 2007, notes investment bank JP Morgan Chase. That looks likely to continue this year. The idea of M&A ramping up is something that tends to get investors excited we all like the idea that a company we own might get sucked into a bidding war. But investors in acquisitive companies shouldbeware: a painful hangover often follows an M&A party, in theform of goodwill writedowns.

You can read a full definition below, but put simply, "goodwill" is a figure on the balance sheet that represents the premium an acquiring company has paid for its target. Or to put it more cynically, as Professor Paul Chaney of Vanderbilt University did in the Financial Times in October, "a lot of analysts view goodwill as the size of the amount that you overpaid for the acquisition". The trouble with goodwill is that the assumptions behind it are highly subjective and thus frequently over-optimistic, which leaves plenty of scope for future disappointment.

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For example, as Al Root points out in US financial newspaper Barron's, food conglomerate Kraft Heinz saw its share price slide by nearly 25% at the end of February, after it was forced to write down $15.4bn in goodwill, reflecting a fall in the value of some of Kraft's key brands. "We were overly optimistic on delivering savings that did not materialise," said then-chief executive Bernardo Hees. In other words, as US investor Warren Buffett who in 2015 backed Kraft's $49bn merger with Heinz admitted, the original deal was overvalued.

So what should investors watch out for? Two things. First, be wary of acquisitive companies. Bitter experience (backed up by research) shows that Kraft Heinz is the norm, not the exception. M&A deals rarely deliver on promises made by management, especially when they're done during periods of high valuations and general exuberance (such as we're seeing in markets today). It's very possible that today's goodwill payment will be tomorrow's regretful writedown it's better to anticipate this than to react to it after the grand scheme has already gone horribly wrong.

Secondly, be wary of companies that already carry a lot of goodwill as a result of past deals. As Root points out, data from analysts Kailash Concepts indicates that "high goodwill-to-assets has been detrimental to forward 12-month returns". In other words, stocks encumbered with a big chunk of goodwill tend to underperform, at least in the short term.

Goodwill explained

Say Company A buys Company B for £10m. The fair value of Company B's assets is £8m. The "excess" £2m paid is then listed in Company A's balance sheet as "goodwill". What does this difference represent? The value of certain intangible assets such as patents or intellectual property can be estimated, and potentially sold separately to the rest of the business.

However, other "soft" assets, such as a strong brand, a highly trained workforce, a solid record of research and development, or a loyal customer base, for example, are much harder to value. They certainly have value, but they arise from the business as a whole being more than the sum of its parts. Goodwill effectively represents the value of these assets to Company A. You could almost argue that goodwill is the value that Company A places on Company B's competitive "moat".

Unlike most other assets, the value of goodwill does not have to be written down (amortised) every year. Instead, accounting rules state that the value of goodwill has to be reviewed every year, and "impaired" (ie, written down) if necessary. Writedowns are deducted from a company's profit-and-loss account, although they don't affect cash flow.

If a company pays less than the fair value for an acquisition perhaps as the result of a distressed sale then it has negative goodwill. This happens rarely, as it implies that the acquirer has bagged a bargain.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.