What does Economic Goodwill mean for the Value Investor?

When the father of value investing, Ben Graham, formalised his approach with David Dodd in the now iconic book Security Analysis in 1934, he made clear his goal of buying stocks at a discount to their net current assets (i.e. cash and other assets which can be turned into cash within one year, such as accounts receivable and inventory, less all liabilities). In advocating this famous Net/Net approach to stock investing, Graham was attaching little or no value to any long-term tangible assets that a firm may possess. For many who studied and ultimately followed Graham, the extreme conservatism of such an approach became increasingly questionable as they grew comfortable in their ability to assign a value to longterm tangible assets such as Property, Plant and Equipment. As the memory of the Great Depression faded, the market began to re-rate upwards in the 1950s and 60s, leaving less Net/Net stocks on offer to investors. Investors such as the legendary Walter Schloss broadened the search for cheap stocks to buying stocks at a discount to their net tangible assets. Although a less conservative approach than Net/Net, this liquidation valuation approach where only tangible assets are assigned a value, has subsequently been viewed as overly restrictive. In particular it lacks the critical insight that many value investors bring to the discipline, including the most successful and well-known value investor of them all, Warren Buffett. The argument that there may be significant value lurking and worth paying for in something Buffett calls Economic Goodwill, which holds little weight for Schloss and arguably held even less for Graham, is a central tenet of the Buffett approach to stock investing. Indeed, given what we know about some of his most successful stock investments i.e. their purchase at a substantial premium to net tangible assets, it is no exaggeration to suggest that his extraordinary investment success would not have been possible without this crucial insight. He succinctly summarised his thinking on this issue in his 1983 letter to shareholders of Berkshire Hathaway: Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalised value of this excess return is Economic Goodwill. Of particular practical significance, this insight of Buffett frees the investor to largely bypass the often thorny issues surrounding accounting goodwill. Questions such as whether goodwill is being fairly valued on the balance sheet by management or, more fundamentally, its definitional failure to capture potentially important assets such as intellectual property can be effectively left to one side, as the investor seeks to value the business in its entirety i.e. its Net Asset Value, as an asset generating market rates of return.

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For such an investor, the business is worth the sum of its net tangible a ssets and Economic Goodwill. The goal of a value investor such as Buffett is to buy stocks at a discount to this valuation. To consider how this approach may be applied, the following example under the following assumptions may be helpful: 1) Total Tangible Assets are assumed to equal the sum of Total Current Assets, Long Term Assets, Net Fixed Assets, Investments in Associated Companies and Other Long-Term Assets on the balance sheet below. 2) Net Tangible Assets is the net of Total Tangible Assets and Total Liabilities. 3) Net Profit is assumed to equate to the Buffett definition quoted earlier of earnings which the business can be expected to produce.
Vodafone - Balance Sheet: March 2010 Assets Cash & Near-Term Cash Other Short-Term Investments Accounts Receivable Inventories Other Current Assets Total Current Assets Long-Term Investments Net Fixed Assets Net Intangible Assets Investments in Associated Companies Other Long-Term Assets Total Long-Term Assets Total Assets Total Tangible Assets Liabilities Accounts Payable Short-Term Borrowings Other Short-Term liabilities Total Current Liabilities Long-Term Borrowings Other Long-Term Liabilities Total Long-Term Liabilities Total Liabilities Net Tangible Assets Net Profit Return on Net Tangible Assets

745 4,066 4,008 433 2,136 11,388 7,650 20,642 74,258 36,377 6,670 145,597 156,985 82,727

3,254 11,184 14,178 28,616 28,686 8,873 37,559 66,175 16,552 8,645 52.23

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Applying these assumptions, this is a business which is generating a return on net tangible assets of over 52%, again to quote Buffett; a return considerably greater than market rates of return. Making the further assumption, that with 10-Year UK Gilts currently yielding below 3.5% and that adding a risk premium of over 5% to this risk -free rate is ample; the reasonable required rate of return for this investment (again in Buffett terms market rates of return) is assumed to be 8.5%. A value can now be assigned to the Economic Goodwill and consequently the entirety of this business i.e. its Net Asset Value, to a value investor such as Buffett:
Net Tangible Assets Economic Goodwill Required Return Net Asset Value 16,522 85,148 8.5 101,700

The current market capitalisation i.e. the Net Asset Value assigned to this business by the stock-market is 75,368 (July 8th, 2010). Thus in this illustration and under the assumptions made, the discount to its Net Asset Value (101,700) which this business is on offer for is just shy of 26%; a margin of safety likely sufficient for many a value investor to take a position. While paying due homage therefore to the ground-breaking work of Graham and the many who have strictly followed his approach with great success, it seems nonetheless clear that the importance of Economic Goodwill to value investing, largely ignored by Graham but introduced by his most famous student Buffett, can often be central.

The Value Investment Institute, July 2010

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