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Hunting Goodwill

Watered stock is an old fashioned term that describes shares of companies with drastically overvalued assets. Reportedly, the term originates with the practice of ranchers feeding their cattle large amounts of water before going to market where the water-induced weight would fetch a higher price. Naturally, the buyer is not happy with this process. The crafty promoter can't take a stock to the pond for a fill up, but there are a variety of ways to mark up assets. A potential source of asset inflation is goodwill, which can be uncovered by investors who are willing to do a little work.

Goodwill arises when one firm purchases another and pays more than the fair market value of the acquired firm's net assets. For example, consider an investor who owns a small fraction of CashCo. CashCo has $100 in the bank and no other assets or liabilities. Keeping in mind that the firm's book value is equal to its assets less liabilities, one can see that CashCo's book value is equal to $100. Putting a value on CashCo is, at first glance, simple. CashCo should be worth $100. After all, should CashCo trade for $90 then a savvy investor would buy CashCo, and keep the $100 for a quick profit of $10. Now, let's consider MixedCo, which specializes in the salty snack business. MixedCo has a variety of assets with a fair value of $100, liabilities of $50, and a book value of $50. Suppose that CashCo's management thinks that MixedCo has good prospects and buys the firm for $100. After the purchase, CashCo has spent $100, but they now have $100 of assets and $50 of liabilities. We are now faced with a problem. After the purchase, CashCo's assets less liabilities, or book value, comes to only $50 whereas before the transaction it was $100. CashCo paid twice book for MixedCo, so perhaps we should just reduce CashCo's book value to $50. Merger specialists and acquisitive managers wouldn't much like an immediate reduction in book value and generally prefer the current accounting convention. Here's where goodwill makes its entrance. Goodwill is the excess amount that CashCo paid over the fair market value of MixedCo's net assets. In this example, a total of $50 of goodwill would be created. After buying MixedCo, CashCo would have assets of $100 plus goodwill of $50, liabilities of $50, and a book value of $100. Goodwill is supposed to represent the intangible qualities of MixedCo such as a good brand name or a loyal customer base. Mind you, it could be that CashCo simply overpaid, which is all too often the case in practice.

The purchase of MixedCo puts the CashCo investor in a tricky spot. They used to know, with a good deal of certainty, that CashCo was worth $100. However, they now have to figure out how much CashCo's $50 of goodwill is actually worth. Did management simply overpay or is there some lasting value to the MixedCo brand? If MixedCo has a good brand name, or some other competitive advantage, then one should be willing to pay a bit more for it. However, the amount that an investor should pay may differ from that paid by CashCo's management.

Goodwill is an intangible asset, which is a fitting classification due to its ephemeral nature. Other intangible assets include patents, copyrights, trademarks and other intellectual property. In many cases these assets are very difficult to price. As a result, it is quite common to consider a stock's tangible book value which is equal to its book value less goodwill and other intangible assets. For instance, after the MixedCo acquisition, CashCo would have a book value of $100 and a tangible book value of $50. Tangible book value allows investors to more directly come to their own conclusions about the current value of a company's intangible assets.

In practice, tangible book value is very handy in uncovering potential cases of watered stock. Many value investors like to look for stocks with low price to book value ratios. With this in mind, I visited on the fourth of June and sorted the forty stocks in the Dow Jones Canada Titans 40 index by price to book value. Eleven of the stocks had price to book value ratios of less than 1.6, which would usually be considered to represent good value (see Table 1).

Table 1: Low P/BV stocks in the DJCT40
Name SymbolPrice/Book
Celestica CLS 0.75
Inco N 0.93
Alcan AL 1.13
Telus T 1.15
Sun Life Financial SLF 1.18
Abitibi-Consolidated AL 1.34
Brascan BNN.A 1.39
Potash Corp POT 1.42
CP Rail CP 1.49
Canadian Natural Resources CNQ 1.52
Ballard Power BLD 1.58
Source:, June 4 2003

Many investors stop at this point but they imperil their savings by ignoring goodwill. The big problem with goodwill is that it often represents overpaying for other companies. Eventually such profligate behavior is revealed and the excess goodwill is written down. Consider the recent high profile, and record breaking, write-downs at AOL which totaled $99.7 billion. Now that's a loss that you don't see everyday, and it eclipsed JDS Uniphase's second-place wipeout of $56.1 billion in 2001. Mind you, these firms weren't alone in overpaying for questionable assets during the internet boom.

With these examples in mind, it seems well worth the extra effort to examine goodwill for the generally more conservative companies found via my low price to book value search. To find goodwill (and other intangible assets), I obtained each firm's annual report at Goodwill is usually listed on a company's balance sheet, but it is sometimes lumped in with other assets and revealed in the financial statement footnotes. I then determined what percentage of total shareholder equity was composed of goodwill (and other intangible assets). The price to tangible book value ratio can then be found by dividing the price to book value ratio by one minus goodwill (in decimal form). Table 2 is sorted by price to tangible book value and it is obvious that discounting goodwill makes a big difference. Three of the firms have price to tangible book values of more than two, which would make them less attractive. Mind you, many of the others remain relatively unchanged.

Table 2: Low P/TBV stocks in the DJCT40
NameSymbolP/BGoodwill (%)P/TB
Inco N 0.93 0.0% 0.93
CelesticaCLS 0.75 27.6% 1.04
Telus T 1.15 10.8% 1.29
Brascan BNN.A 1.39 4.1% 1.45
Potash CorpPOT 1.42 4.6% 1.49
CP Rail CP 1.49 0.0% 1.49
Canadian Natural ResourcesCNQ 1.52 0.0% 1.52
Alcan AL 1.13 31.2% 1.64
Sun Life FinancialSLF 1.18 44.8% 2.14
Ballard PowerBLD 1.58 43.2% 2.78
Abitibi-ConsolidatedAL 1.34 62.4% 3.57
Source: June 4 2003 &

Goodwill is not the only thing that leads to misleading book values. Because book value typically contains a variety of current and historical data, it can be very difficult to get an accurate book value. For instance, many companies own land which is carried on the books at cost. If the land in question is in downtown Toronto and it was purchased many years ago then it is quite likely to be worth more today and represents a hidden bonus for equity holders. On the other hand, some machinery may have been made obsolete more quickly than expected due to technological change and is now worth less than indicated on the balance sheet. Similarly, firms with claims to natural resources may have incorrectly estimated the value of these resources. Shareholder equity is also complicated by the existence of preferred shares and per share amounts are plagued by stock options.

Given the potential pitfalls associated with book values, why is it used by investors? Perhaps the simplest reason is because it has worked. Generally speaking, low price to book value stocks have outperformed their high price to book value compatriots over the years. Book value also provides a good second check on stock prices determined by more traditional earnings or cash flow valuation techniques. It is always useful to check for excessive water before buying based on book values.

First published in July 2003.

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