This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
TheStreet Open House

Be Wary of Stocks That Grow Via Goodwill

NEW YORK ( TheStreet) -- Goodwill is an accounting concept anyone who has investigated financial statements likely has encountered. It usually shows up in the balance sheet as a long-term asset on its own line item titled simply "Goodwill" or sometimes "Cost in Excess."

What does this asset value represent?

When a company purchases more than 50% of another company, it is required by accounting laws to consolidate all of the assets and liabilities of the purchased firm. However, it is very rare that an acquiring company pays just book value for another firm. Many companies are bought out at three, four, even 10 times book value. This is where the goodwill line item comes in. Any portion of the purchase price in excess of book value is placed into the goodwill account of the acquiring firm's balance sheet. So, in short, goodwill represents the cumulative amount of money paid for acquired assets above their book value. It is a decent shorthand for the amount of value expected to be generated from an acquisition.

A much more detailed example of goodwill accounting can be found here.

So how does this relate to Magic Formula Investing? As one of the core adjustments made in calculating a comparable return on capital, Joel Greenblatt subtracts goodwill from total assets. Ostensibly, this is to remove accounting differences that occur from company to company and compare firms based solely on their returns on tangible assets.

However, removing goodwill when calculating return on capital fails to penalize companies that routinely overpay for acquisitions in order to grow. In effect, MFI can reward "empire building" in which firms will pay any price to keep the revenue and profit lines rising at rates that satisfy Wall Street.

But overpaying for acquisitions doesn't create value. It simply removes capital that could have been returned in the form of dividends or share buybacks.

To illustrate how ignoring goodwill can skew the Magic Formula's view of a company, take the case of current Viacom (VIA - Get Report). The company lists more than $11 billion of goodwill, about 50% of total assets. Most of this has built up in a complex web of acquisitions over decades. For example, many of Viacom's cable channels (like CMT and VH1) were obtained via acquisition.

1 of 3

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Try it NOW
Only $9.95
Try it NOW
14-Days Free
Try it NOW

Check Out Our Best Services for Investors

Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
Try it NOW
Try it NOW
Try it NOW
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
SYM TRADE IT LAST %CHG
UNTD $15.67 0.00%
ARO $3.30 0.00%
DLX $66.93 0.00%
LO $68.19 0.00%
PDLI $7.04 0.00%

Markets

DOW 17,712.66 +34.43 0.19%
S&P 500 2,061.02 +4.87 0.24%
NASDAQ 4,891.2190 +27.8570 0.57%

Partners Compare Online Brokers

Free Reports

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs