Understanding Goodwill as an Intangible Asset

When you go through the annual report of any company, you will find “Goodwill” under Non-Current Assets in the Balance Sheet. But wait, what is this Goodwill?

Before that, let’s understand what an asset is. Basically, anything that has the power of generating current, future, or potential economic benefits is called an asset. So, that would cover everything that you own or that someone else owes to you.

But it just so happens that people usually name land, buildings, cars, computers, and other stuff that they can touch and feel when discussing assets. So, these are the Tangible assets. However, very few people often talk about things that aren’t tangible but are assets.

So, here’s your guide to one of the most important intangible assets of any business, the Goodwill.

What is Goodwill?

In general, we mean goodwill to be ‘reputation,’ the advantage of a company over others. And quite often, people get confused when they notice ‘goodwill’ in an annual report. So, since it is mentioned under ‘Assets’, does it mean that the company expects some future cash inflows from it? What does this goodwill tell about the company?

In investing terms, this goodwill is known as “Accounting goodwill”, and it comes into existence at the time of a scheme of amalgamation or merger. This means that whenever any company acquires another company, the goodwill may come into existence. This has no relation whatsoever with the brand value or moat or customer stickiness generated by the company.

How does Goodwill come into existence?

Suppose, in a scheme of acquisition or merger, if the acquiree company pays, say Rs 1000 Crore, for the net asset of say Rs 800 Crore; the balance of Rs 200 Cr, which is paid in excess of the net asset, is recorded as “Goodwill”- the accounting goodwill of the company.

For instance:

(Source: Zydus Wellness Ltd FY20 Annual Report, from Ticker)

The goodwill of Rs 2282 Lac, as recorded in the books of Zydus Limited, dates back to 2008-09 when it acquired Liva HealthCare Limited. This goodwill is a result of accounting adjustments at the time of acquisition. You might find goodwill in several other companies- Infosys Limited, Tata Chemicals Limited, Happiest Mind Technologies Limited, etc.

(Source: Infosys Ltd FY20 Annual Report, from Ticker)

Interpretation of Goodwill

The goodwill so recorded in the books may not realize any cash in the future, and thus, we have to be careful while valuing the company based on its total assets (book value approach). If the asset side of the balance sheet shows a total of 1000 Cr, and the value of goodwill shown is 200 Cr, consider the net realizable asset to be 800 Cr, and the intrinsic value per share should be adjusted accordingly. 

One important conclusion that can be drawn from here is that if you find goodwill increasing on a year-to-year basis, that doesn’t mean that the company is enhancing its market reputation. Still, it simply means that the company is indulged in a lot of business take-overs and mergers. Also, a decline in goodwill would not mean that the company's reputation is deteriorating year by year. It just means that the company is writing off the goodwill from its Balance sheet slowly by charging it against the profits.

So, what kind of goodwill actually benefits the company?

Economic Goodwill

Economic goodwill can be thought of as the source of earning power that will make you fortunes even in the dreaded economic times. It is not reported on the balance sheet, but it is one of the significant parameters that need to be assessed while buying a business or a part of it because - “…reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.”

Looking beyond the Annual Report of a company...

It is the intangible assets of a company that plays a phenomenal role in enhancing its earnings. It is that driving factor that provides an edge to the company over its competitors. It can be its brand value, customer stickiness, the habit of the product among customers, or customer loyalty. It reflects something, which cannot be measured, and hence, these are not a part of the company’s Annual report. 

The value of such economic goodwill can be more than the value of all assets of the company combined. Do you still think that you need to learn all the number-crunching to be a good investor?

Number crunching is essential, but the most important factor in your investment decision is not a number! It is something that has to be felt and analyzed. Found a new product in the market making things easy for the masses? It can be the next multi-bagger.

Pidilite Industries Limited is known to provide almost 200% returns in the last five years. It manufactures Fevicol, a product not only needed for furniture but something that even a five-year-old cannot live without.

The Bottom Line

So, what's in numbers? You won’t find real economic goodwill there. Try to analyze a company with the potential of its intangible assets. Try to look for the moat of the company, the competitive advantage it has over others. The annual report might tell about the past of the company and its future prospects, but it cannot determine its future.

Because if number-crunching was everything needed for being a successful investor, supercomputers would have been super investors! But are they?

Anyway, what’s your opinion on the importance of Goodwill in investment decisions? Tell us.