10 Balance Sheet - Goodwill
In this lecture, we look at goodwill. To some, goodwill is a rather meaningless accounting entry. It simply represents the difference between the price paid for an acquired subsidiary and the market value of the assets acquired. To the extent that goodwill used to be written off over the life of the asset, that would still be true today.
But goodwill is generally now not amortised but must be tested for impairment each year. And it’s this requirement to do an impairment test, which can yield useful information to the skilled analyst. The assumptions the company makes around the impairment test gives some useful info:
- Are the discount rates being assumed sensible and appropriate to the business?
- What revenue and margin assumptions are being made? Are these consistent with market expectations? You would expect the CFO to be conservative but if this is say a roll-up business and the revenue growth is assumed to be 1% overall and the market is going for 5%, it’s important to understand why there is such a difference.
Companies often test for goodwill by combining acquired businesses into Cash Generating Units or CGUs – this can give them the opportunity to avoid making an impairment. Watch for changes in the CGUs, as they may indicate trouble brewing.
Note that there are no fixed rules for how companies allocate goodwill to CGUs, or as to how they present or explain their assumptions in the goodwill note. Hence you need to read the note and assess whether you are being told the whole truth, and to infer from the language and changes in language and presentation, whether there may be any issues in the business, or the accounting, which should put you on alert for problems ahead.
Here is another example: Compass Group, the contract caterer. A pdf of its goodwill note is attached. The group organises its goodwill by geography:
The table lists the growth rates assumed and the discount rates applied for the last two financial years. Checking what has changed is a useful indicator as to whether there might be any issues – if a subsidiary is in danger of needing a goodwill write-down, and the management wish to disguise that need, one solution is to take the assumptions driving the internal valuation (which is then compared with the carrying value to determine if a goodwill write-down is required).
In the case of Compass, the discount rate in the USA has fallen significantly, but so have bond yields in the period and the assumption on revenue growth has declined, from 2% to 1.9%. Had the revenue growth assumption also been increased, this should have put the analyst on guard, especially if the discount rate had fallen by more than was warranted by the external environment.
A good example is Canada – the discount rate has declined and the growth rate has been revised up. Although Canada is unlikely to be significant to Compass, I would normally have asked the IR a couple of questions about the Canadian business to check there was not a problem there. Similarly in Japan.
Goodwill is an accounting construct and many analysts simply ignore it, but there is a lot of useful information to be gleaned by the diligent analyst, simply by reading the goodwill note and watching for aggressive assumptions or changes in them.