Investors should consider factoring in goodwill when they are examining the value of a stock, because it can often predict the outlook of a company, especially serial acquirers.
Retail investors should care about the amount of goodwill included in a company's valuation even though it is often ignored, said Michael Berger, founder of Technical420, a Miami-based company that conducts research on cannabis stocks. A company's goodwill represents its brand reputation, loyalty, along with patents or proprietary technology and adds significant value.
"We think this is somewhat related to the rise of cult stocks and 'unicorn' investments," he said. "Many investors do not care about the amount of goodwill in companies like Tesla (TSLA - Get Report) or Netflix (NFLX - Get Report) ."
While goodwill is often underplayed, it remains one of the most important balance sheet indicators to determine what a company is doing, said Edison Byzyka, chief investment officer of Hefty Wealth Partners in Auburn, Ind.
"Goodwill is the residual amount of what a company is worth and the value that someone will pay for it," he said.
Firms such as Coca Cola (KO - Get Report) , General Electric (GE - Get Report) , International Business Machine (IBM - Get Report) and Johnson & Johnson (JNJ - Get Report) routinely have 20% to 30% of their intangible assets in goodwill. For publicly-traded companies, goodwill is the difference between the total assets and total tangible assets, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla.
"Shareholders can consider that goodwill is the intangible portion of the assets they pay for," he said. "Maybe a more relevant question is that why the market is willing to pay a positive value to goodwill or some asset which is intangible."
When the goodwill of a company is deemed positive due to the "perceived value from the visionary founders or management's personal fame and charisma," it can boost a stock's valuation, Ma said.
"Loyal followers of Tesla's Elon Musk and Under Armour's Kevin Plank consistently pay premium for founders' promises and both companies have 20-30% of goodwill on their books," he said. "There are always investors willing to pay for high-growth stories which have neither revenue or profit in sight. For an unproven business model, what shareholders are paying is all goodwill."
When companies face scrutiny from the public and regulators because of customer service complaints, food service crises or large data breaches, goodwill can be affected.
It is questionable whether the perception of a decline of goodwill has a long-term impact on a stock's price like Chipotle Mexican Grill (CMG - Get Report) , Sears (SHLD) and United Continental (UAL - Get Report) , experts said.
The amount of goodwill factored in retailers which have reported declining sales for years is also confounding, said Patrick Morris, CEO of New York-based HAGIN Investment Management. At the end of the third quarter, Sears' balance sheet showed $1.9 billion in trade names and other intangible assets.
"It's a total mystery to me," he said.
The $2.5 trillion of goodwill on the balance sheets of corporations is alarming, especially the high values for tech companies like LinkedIn (LNKD) and Twitter (TWTR - Get Report) , which rely on it to support their "lofty" valuations, said Morris.
The amount of goodwill may have larger impacts on well-known companies like United. Before its public relations snafu with an elderly passenger who was assaulted, the United was carrying $4.5 billion of goodwill as of Dec. 31, 2016, a number that has been unchanged in 2014 and 2015.
"The value of goodwill on the books must have taken a big haircut in the past several months," he said.
Calculating goodwill is tricky and not an exact science because the true value of it is "really based in the eye of the beholder and it can either be discounted completely or considered woefully understated," said Ron McCoy, a portfolio manager of the LOWS fund (Levered Options Writing Strategy) with Covestor, the online investing company and chief investment officer at Freedom Capital Advisors in Winter Garden, Fla.
When investors deem that a company really has no "real" intangible value other than their assets as listed, then the goodwill listed on the books becomes meaningless to the long-term value of the company.
"In many restructurings, it is common to write down this goodwill as the dynamic of a negative change in the business environment has rendered it obsolete," he said.
Goodwill is likely a fair metric when a brand's image is solid, said Morris.
"It's a unicorn, if you try to catch it when things are going south you're going to be very disappointed," he said. "Companies which have a brand that is in the public eye, the value of goodwill can change so quickly that it has to be considered an almost useless figure."
How Acquisitions Impact Goodwill
Companies which are acquisitive often have "lots of goodwill as their main assets and this distorts their real book value by many multiples," said McCoy.
When a company's valuation is dependent on a large amount of goodwill, it can be disastrous if they are forced to sell themselves or file for bankruptcy.
"One stumble in the plan and you find out there isn't much left to liquidate if things go wrong," he said.
Companies with a stable history of "prudent acquisitions with brands and relationships" often find themselves in the enviable position of a high market valuation.
"That is why you often see takeovers at 30% plus premium to the market as the acquirer is willing to pay a premium to the market to get those under appreciated intangibles," added McCoy.
Goodwill's Impact on Tech Firms
Tech firms are rarely judged by goodwill and rely on other factors such as revenue growth and the total profit potential of their markets, said Barry Randall, a technology portfolio manager with Covestor, the online investing company based in Boston and London.
Goodwill is often viewed as irrelevant to the valuation of companies such as Facebook (FB - Get Report) which have few assets. When Facebook purchased WhatsApp for $21.8 billion in cash and stock in 2014, Facebook's accountants assigned a total fair value consideration of $17.2 billion to the WhatsApp acquisition. In this merger, $15.3 billion was accounted for as goodwill.
The goodwill in this acquisition appears to be extremely high when WhatsApp was a fairly new startup and lacked a proven business model, he said.
"I don't know what's more amazing, that the WhatsApp purchase added $15.3 billion in goodwill to Facebook's balance sheet where it sits, unchanged even today or that Facebook's accountants valued the net assets acquired from WhatsApp at $1.85 billion at a time when WhatsApp had only a few dozen employees and was generating about $20 million in annual revenue," said Randall, which analyzes and invests primarily in technology companies, owns shares of Facebook personally and for client accounts. He does not own shares of any other companies mentioned.
Investors are not likely to care that 28% of Facebook's total assets were represented by goodwill.
"If Facebook is able to more fully monetize WhatsApp's 1.2 billion monthly active users, then it can 'overpay' for WhatsApp and generate a massive amount of goodwill for their balance sheet," he said. "That goodwill could very well represent an immense financial upside."
Hardware-oriented companies such as Intel (INTL - Get Report) are not able to monetize acquired assets to the same extreme degree. Goodwill represented only 12% of Intel's total assets from acquisitions like McAfee and Altera.
"There's vastly more leverage in acquiring a free texting app than in acquiring a building and its equipment since the assets of the latter need maintenance and talented people to run," Randall said.
Editors' pick: Originally published April 28.