At the end of Warren Buffett’s 1983 letter, there was an appendix discussing on economic and accounting goodwill.
When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired.
Frequently the sum of the fair values put on the assets (net of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account called “Goodwill”.
This accounting goodwill is then amortized (typically) over a period of 40 years to the earnings account.
For example, Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. See’s was earning about $2 million after tax at the time. This works out to a very impressive 25% returns on assets.
Blue Chip’s purchase of See’s at $17 million over net tangible assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years to amortize that asset.
Thus, instead of $2 million, earnings will be reflected as $1.575 million on the accounts.
If See had been bought at a price of $88 million, the amortization of $80 million over 40 years will be reflected by a net earnings of $0 on the accounts.
If you think about it, the economics of See’s business has not really changed even though the two purchase price were different. Yet, the income sheet tells a drastically a different story.
Different purchase dates and prices can give us vastly different asset values and amortization charges for two pieces of the same asset.
Consider another business B that is earning $2 million on assets of $18 million. Earning only 11% on required tangible assets, this mundane business would possess little or no economic Goodwill.
A business like B might been sold for the value of its net tangible assets, or for $18 million. In contrast, $25 million was paid for See’s, even though it had equal earnings and less net tangible assets!
Could less really be more?
The economic goodwill of See is much greater than B. If earnings of $4 million is to be achieved, See would require only an additional $8 million in capital while B would require a good $18 million.
See would now be worth $50 million (if valued on the same basis as originally). It would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.
B would be worth $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested.
Asset-heavy businesses 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.
On another note, if an overexcited management purchases a business at a silly price, this silliness ends up showing up as Goodwill in the accounts. It remains on the books as an “asset” just as if the acquisition had been a sensible one!