Capital structure
The Rise of the Intangible Economy
Goodwill, which we should think of as ‘Accounting Goodwill’, appears on balance sheets when a company acquires another company for more than the book value of its tangible assets. We need to introduce another concept. This is the idea of ‘Economic Goodwill’.
For purposes of this post I will lump together goodwill and intangibles. They come about in different ways but they are both Intangible Assets.
Warren Buffett says: “…You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.” 1983 Berkshire Hathaway, Chairman’s letter to shareholders, quoted in (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p171. (Emphasis Added)
This was written before the 2004 change in the accounting treatment of Accounting Goodwill. Previously Accounting Goodwill was amortized. The 2004 change did away with that and now Accounting Goodwill is tested for impairment. Today some Accounting Goodwill is amortized and some intangibles are amortized. For present purposes we don’t need to get into that. The simple fact is that today more Accounting Goodwill remains on balance sheets. But, Economic Goodwill remains off the balance sheet. You are right. This is confusing. This makes it even more important to understand what Buffett is saying.
Warren Buffett make a clear distinction between Economic Goodwill and what he calls, ‘spurious accounting goodwill.’ (Buffett, 1998) p.176. He defines Economic Goodwill as follows: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.” (Buffett, 1998) p.173.
Minimum of tangible assets
Buffett goes on: “Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring [economic] Goodwill and that utilize a minimum of Tangible Assets”. (Buffett, 1998) p171.
Put another way, he says:
“Asset-heavy businesses [he’s referring to tangible assets] generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined Intangibles of lasting value with relatively minor requirements for Tangible Assets.” (Buffett, 1998) p176. (Emphasis added)
Intangibles of lasting value
Our discussion of Economic Goodwill has now expanded to include ‘Intangibles of lasting value’. It might actually make sense to replace Buffett’s term Economic goodwill with the term Economic Intangible Assets of Lasting Value, but that would be a mouthful. I tend to simply use the term Intangible Assets to refer to all goodwill and intangibles that are of lasting value.
So, Accounting Goodwill is an accounting creation that comes into existence on some take overs. Economic Goodwill is an Intangible Asset that is created internally over the years by the company, although it may include Accounting Goodwill. But, Economic Goodwill, for the most part, does not appear on the balance sheet except in very constrained circumstances.
Microsoft Corp.
By way of example, let’s look at the balance sheet of Microsoft Corp. (MFST). See below. I have simplified it to show only what we need to talk about.
If you sum up the ‘Goodwill, Net’ and ‘Intangibles, Net’ for the year ended June 30, 2022 you get about $78 billion. Between them they make up about 20% of Total Assets. The rest of the Total Assets are Property/Plant etc., and Current Assets (not shown).
Total Equity is $166,542 million. For investment analysis purposes we call this the book value of equity. The book value of equity is comprised of Goodwill/Intangible assets of $78 billion and the rest is Tangible assets.
But, here’s the kicker. The market prices the common shares of Microsoft at $1.9 trillion. That is the market capitalization of equity. Unless the stock market is totally crazy (conceivable but unlikely here), the stock market puts a price on equity of $1.9 trillion and the balance sheet puts a value on equity of $166,542 million or $.167 trillion.
The book value of Goodwill/Intangible assets is $78 billion. Thus, in Warren Buffett’s terms, the company’s Accounting Goodwill is $78 billion. The Economic Goodwill is in the order of $1.9 trillion.
| Assets | |||||
| In Millions of USD (Except for Per Share Items) | 30-Jun-19 | 30-Jun-20 | 30-Jun-21 | 30-Jun-22 | |
| Property/Plant/Equipment, Total – Net | 43,856 | 52,904 | 70,803 | 87,546 | |
| Goodwill – Gross | — | — | — | 78,824 | |
| Accumulated Goodwill Amortization | — | — | — | -11,300 | |
| Goodwill, Net | 42,026 | 43,351 | 49,711 | 67,524 | |
| Intangibles – Gross | 17,139 | 17,759 | 19,975 | 23,577 | |
| Accumulated Intangible Amortization | -9,389 | -10,721 | -12,175 | -12,279 | |
| Intangibles, Net | 7,750 | 7,038 | 7,800 | 11,298 | |
| Total Assets | 286,556 | 301,311 | 333,779 | 364,840 | |
| Liabilities | |||||
| In Millions of USD (Except for Per Share Items) | 30-Jun-19 | 30-Jun-20 | 30-Jun-21 | 30-Jun-22 | |
| Total Liabilities | 184,226 | 183,007 | 191,791 | 198,298 | |
| Shareholder Equity | |||||
| In Millions of USD (Except for Per Share Items) | 30-Jun-19 | 30-Jun-20 | 30-Jun-21 | 30-Jun-22 | |
| Total Equity | 102,330 | 118,304 | 141,988 | 166,542 | |
| Total Liabilities & Shareholders’ Equity | 286,556 | 301,311 | 333,779 | 364,840 |
Comparing tangible vs intangibles assets
Buffett’s insight is fascinating. Property, plant and equipment need regular doses of capex. An indicator for this need is depreciation in the financial statements. As well, five year summaries of financial statement will show the amount spent annually on capital projects.
For many companies with large Intangible Assets there may be little need to spend money to maintain them (think of broadcast licenses). An indicator here would be low amortization in the financial statements and no impairment charges on Intangible Assets.
Buffett contrasts some media and communications businesses with relatively minor need for Tangible Assets with some industrial enterprises such as car makers, with a huge and continuing need for capital expenditures to remain competitive.
It’s dangerous to generalize
One qualification is needed. Some companies with a low level of Tangible Assets and high level of intangibles sometimes need to spend a lot of money to maintain and address obsolescence in their Intangible Assets. So, there is a risk to generalizing about the benefits of intangibles.
Companies that spend a great deal on intangibles R&D such as software are sometimes compelled to incur high levels of annual R&D spending just to keep up with the competition. In a sense, this compelled intangibles spending is comparable to high levels of capex spending by some companies on their Tangible Assets to remain competitive.
As Warren Buffett put it in his 2015 annual letter to Berkshire Hathaway shareholders in February 2016: “…serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value.”
Haskel and Westlake discuss this in a section titled ‘Accounting Treatment of intangibles: Expensing versus Capitalization’. Their conclusion is that: “Financial investors who can understand the complexity of intangible-rich firms will also do well. The greater uncertainty of intangible asset and the decreasing usefulness of company accounts put a premium on good equity research and on insight into firm management.” (Haskel & Westlake, Capitalism without Capital, The Rise of the Intangible Economy, 2018) p207. (Emphasis added)
Haskel and Westlake explain the complexity this way: “… intangible investment has a tendency to be more uncertain. First of all, owing to its sunkenness, intangible investments tend to be worth less if they go wrong. It’s harder to recover their value by simply selling them. Second, the upside of an intangible investment is potentially much higher since it is more likely to benefit from scale (so a modest investment can reap a big return) or synergies (increasing its value directly). So when things go wrong intangibles tend to be worth less and when they go well, they tend to be worth much more.” (Haskel & Westlake, 2018) p87. (Emphasis added)
The special terms discussed at some length by the authors along with spillovers and are part of their overall thesis that intangible investments and Intangible Assets have ‘unusual economic properties’ leading to the rise of the ‘intangible economy’.
The flip side
The discussion above was about how the rise of Intangibles Assets of lasting value may be understated on company balance sheet and thus, that debt/equity ratios may be distorted and sometimes meaningless. There is a flip side.
Sometimes the Book Value of Equity is overstated.
Book Value has a reassuring sound to it. Don’t the accountants have to sign off? In reality some companies with substantial Book Value per share are virtually worthless. In fact, a low Price to Book Value may be a sign of a company in distress. Peter Lynch points out that Penn Central, which was, at the time the largest corporate bankruptcy in American history, had a Book Value of $60 per share when it declared bankruptcy.
There may be many occasions when book value fails to reflect serious obsolescence of the company’s productive assets.
Inflation and balance sheets
Inflation can have an impact. If inflation has caused the depreciated replacement cost of company assets to soar, and if the assets are not obsolete, a company may have valuable assets that give it a cost advantage over competitors who have to pay inflated costs to replicate a company’s assets. In effect, the assets on the balance sheet are understated. On the other hand, if the assets are obsolete and in need of replacement, a company may be in need of replacing assets at an inflated cost and the assets on the balance sheet may, in effect, be overstated.
Capitalized expenses
Book Value may include capitalized expenses in relation to a company’s assets. A company may have spent enormous sums of money on prestige projects that will never generate value for shareholders. Management may be reluctant to write them down or write them off because this would be an admission they capital expenditures were not well made and write offs will impact on the value of management stock options, profit sharing plans, performance share units or stock appreciation rights or other such incentive plans.
‘Book Value’ can be a misleading
Inventories are a particularly tricky item on balance sheets. Inventories of finished or semi-finished products may be worthless. Mortgages, derivatives and other financial instruments on the asset side of banks, insurance companies and other financial services companies may be in arrears but not adequately provided for, or not marked to market value or in other ways not properly valued. Real estate developers typically are allowed to capitalize expenditures on land and even interest payments so that they show up as assets on the balance sheet even if they cannot be sold at those values.
These are simply a few examples that illustrate why ‘Book Value’ can be a misleading indicator of intrinsic value.
What it all means
The amazing thing is that Warren Buffett’s concept of Economic Goodwill and his “preference for businesses that possess large amounts of enduring [economic] Goodwill and that utilize a minimum of Tangible Assets”, was written about in 1983. The economy has changed dramatically since then. Today most corporate capital investment is in intangibles not in tangibles.
This phenomenon has massive consequences for reading and understanding financial statements. Most of Microsoft’s assets are not listed on its balance sheet!! Things like debt/equity ratios, Return on Equity (ROE) and Return on Capital (ROC) are so distorted as to render them almost meaningless.
Conclusion
Warrant Buffett has done all investors a favour by drawing a distinction between Accounting Goodwill and Economic Goodwill. If you don’t understand this distinction, I don’t know how you can invest in any sensible way in today’s intangible economy.
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For readers wishing to dig a little deeper into the topic of company investment in intangibles of lasting value, take a look at these posts:
The emergence of a new model of capitalism
Financial strength – the debt equity ratio has serious shortcomings
Be wary of using Return on Capital (ROC)
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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