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). 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.