Be Wary of Stocks That Grow Via Goodwill

Overpaying for acquisitions doesn't create value; it removes capital that could have been returned in the form of dividends or buybacks.
By Steve Alexander ,

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.

Removing goodwill from a MFI pretax return on capital equation has a drastic effect on results:

Return on Capital (minus goodwill) = EBIT/(Invested Capital - Goodwill) = 3,277 / (17,628 - 11,035) = 53.5%

Return on Capital (with goodwill) = 3,277/ 17,628 = 18.6%

Not accounting for Viacom's history as a highly acquisitive firm makes the company look a lot more efficient than it actually has been.

Now let's look at the opposite side of the equation: a Magic Formula stock with no goodwill, which has generated high returns on capital strictly through organic growth. One such stock is

Aeropostale

(ARO)

.

Return on Capital = 402.2/(374.8 - 0.0) = 107.3%

Clearly, a 100% organic return on invested capital is far more impressive. In general, firms that can deliver high returns on capital from organic means are more attractive investments than those that have grown through acquisitions.

In addition, companies with little or no goodwill won't face surprise "goodwill impairment" charges that artificially reduce earnings per share, making their price-to-earnings multiples look worse than they otherwise would.

To whittle down the current Magic Formula stock universe to just the companies that grow primarily through organic means, I've calculated the firms at which goodwill and intangibles represent less than 10% of total assets.

These represent the current MFI stocks that are least affected by the strategy's ignorance of the "acquisition penalty."

There you have it, a list of firms with truly great returns on invested capital and a penchant for growing through internal means instead of buying it up at high prices, in most cases. Investors should still do their own due diligence. Firms like

Seagate

(STX) - Get Report

have written off large portions of bad acquisitions in the past (i.e. the Maxtor deal), and

Intel

(INTC) - Get Report

has made recent purchases that are not yet reflected in its financial statements (i.e. the acquisition of

McAfee

).

On the other side, here are the top 10 Magic Formula stocks with the highest amount of goodwill as a percentage of total assets. These are your "serial acquirers," companies whose wheelin' and dealin' nature should be scrutinized before investing in them.

Alexander owns AFAM, VECO, WDC and SNDK

.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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