Taking the Mystery Out of Goodwill

Our Motley Fool Industry Focuspodcast hosts dive into the topic of goodwill, breaking down this concept that so often confuses investors. Learn what goodwill is, how it gets recorded on a company's balance sheet, and why it's so important to consider when two companies merge.

A full transcript follows the video.

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This video was recorded on March 21, 2017.

Vincent Shen: Ben wrote, "I was wondering if you could give your thoughts on goodwill, especially when it's over 40% of assets on a common size balance sheet. FactSetis a very interesting company, but I am of the belief that goodwill is a filler on the balance sheet, so whenever I see it this massive, I question it."

FactSet would traditionally fall under the purview of Gaby and the Financials segment of Industry Focus, but I think the topic of goodwill is a very important one to cover for the consumer retail industry. We can also talk a little bit about FactSet as a company as well, it's a very interesting business. Let's start with, for goodwill overall, Asit, can you give me a rundown of what Ben is referring to here, and just how to look at it?

Asit Sharma: Sure. Goodwill represents the excess of fair value in an acquisition. We typically think of goodwill when one company acquires another. I'll give a really simple example between myself and Vince. Vince has a frisbee to sell me, and I decide that I really like this frisbee because I play ultimate frisbee. It's a red frisbee with golden trim, and it's selling for $2 on the market. But I really like this frisbee. And Vince knows that I really like it. And he and I agree that I'm going to buy it for $10. So, once the transaction takes place, I go home and sit down and do my accounting. I record that there was an outlay of $10 cash. That's one side of the ledger, $10 goes out. Then, what do you think I record the frisbee value at? Do I record it at $10 or $2? Vince, what do you say?

Shen: Well, the frisbee value, according to the purchase accounting method, for the frisbee itself, would be recorded at $2.

Sharma: Absolutely. So, I put the asset on my books at $2, and there's an $8 hole to fill on my balance sheet, and I book that to an intangible asset called goodwill. Two ways you can look at that $8: either it represents something that, in the future, I can get value out of, I have this knowledge that someone else is going to want that frisbee for even more, because they recognize the same things I do. You can also look at it like, "Asit, why did you pay $8 for a frisbee which had a fair market value of $2?" And this gets to the heart of a lot of questions about goodwill. Whenever you see a company acquiring another company, you're curious: Has a fair purchase price been paid? Or has one company overpaid for another?

Shen: I think that's a really nice, simple example to present it. Ultimately, the question becomes, what does that goodwill represent in a lot of cases for these bigger, complicated M&A deals between companies? For the frisbee, maybe it's because it happens to be the frisbee that was played in a winning championship ultimate frisbee game, so it has that extra good luck juju, and that's why you're willing to pay the extra $8 for that goodwill. But for actual acquisitions, it might be things like brand power, top-tier management or employees, a loyal customer base -- things that just don't end up being reflected when you add up all the hard assets like factories or inventories or patents, cash balances, on the buyout target, but they still have excess value that needs to be reported in some way in the books, and as you described, Asit, that's where it goes to goodwill.

A big example beyond FactSet, I want to anchor it to the consumer retail space, one of the bigger deals in recent memory was the Kraft-Heinz (NASDAQ: KHC)deal. For accounting purposes, Heinz was identified as the acquiring company. They paid $53 billion in total consideration for Kraft. But the identifiable stuff that they mentioned -- and you can find all of this in their 10-Q and 10-K filings -- they have $314 million in cash, they have about $4 billion in property, plant, and equipment, and intangible assets of about $48 billion. But when you take out the liabilities, because this is supposed to be the net assets, you take out things like payables, long-term debt, then in all, the identifiable assets less liabilities they acquired came out to just $22 billion. So, the rest of that consideration they paid, which amounted to over $50 billion, that difference is our goodwill.

And the company specifically states in its filing that "The 2015 merger resulted in $30.5 billion of non tax-deductible goodwill, relating principally to synergies expected to be achieved from the combined operations and planned growth in new markets." Just an example there specific to the consumer retail sector for a very big deal that has happened in the past couple years.

prginww has no position in any stocks mentioned. The Motley Fool owns shares of and recommends FactSet Research Systems. The Motley Fool has a disclosure policy.