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.
Attached is a commentary from Edelweiss which discusses goodwill. They raise some of the same points which I make, but I disagree with their comments on the last example, which has some unusually granular disclosures and where the reduction in the already high-ish discount rate is tiny, while some of the assumptions are more conservative. I don't know the stock or the details, but I think the changes in the long term growth rate, for example, are significantly more conservative and this outweighs the minor reduction in the discount rate.