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) 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) 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.