Forum Archive Index - November 2000

["Warner Lamb" <cloud9@i4free.co.nz>]

Brian, this is very long but I thought it was very interesting and a clear
view on Goodwill and Amortization from Buffett. Goodwill is not the
precieved evil paid for intangable assets but acording to him can be a
blessing.

The following from "The Warren Buffett Way" Pg 61-62 (acknowledging Robert
G. Hagstrom Jr.)

Accounting goodwill, in contrast, will not remain steady; because of
accounting practices, it must diminish. According to generally accepted
accounting principles (GAAP), when companies are purchased for an amount
larger than the net assets (assets minus liabilities), the extra value is
assigned to the asset side of the balance sheet and is entitled goodwill.
like other assets, this goodwill is then amortized over a fourty year
period. Each year, one- fourtieth of the value of goodwill is reduced and
charged against earnings.(the following is an example) Since Blue Chip
Stamps purchased See's for $17 million over it's tangible assets, a goodwill
account was established on the asset side of Blue Chip's balance sheet. Each
year, one- fourtieth of this goodwill, or $425,000, is reduced on the
balance sheet and charged against earnings. Over the years, then, See's
accounting goodwill has been reduced, but the economic value, as long as
see's continues to prosper, continues to grow.
Economic goodwill not only produces above average returns on capital but
it's value tends to increase with inflation. This appreciation is
fundamental in understanding Buffett's equity-investing strategy. To
illustrate how this works, Buffett compares See's financial operations with
a hypothetical company I will call Bee's. See's you recall, earned $2
million on $8 million of assets. Buffett asks us to assume that Bee's earns
the same $2 million but needed $18 million in assets for it's operations.
Bee's is earning 11 percent on capital and likely possesses little or no
goodwill. Bee's probably would sell for $18 million, the value of it's
assets, since it is only able to generate an average return on those assets.
Remember, companies that are able to generate above average returns on
capital often recieve a purchase price greater than their net assets.
Buffett paid $25 million for See's, $7 million more than the value of Bee's
even though the earnings of these companies are identicle and See's has half
as much in identifiable assets. Buffett asks us to consider if See's with
fewer assets, is really worth more than Bee's. The answer is "yes", Buffett
says, as long as you believe that we live in a world of continuous
inflation.
To appreciate the effect that inflation has on these two businesses, imagine
what would happen if inflation doubled costs. In order to maintain the same
level of profits, both companies would need to increase earnings to $4
million. That is not difficult, even if volume is flat and margins are
unchanged. You can double your profits if you double your prices. The
crucial difference between See's and Bee's is the effect that inflation has
on assets. Inflation allows both companies to raise their prices, but it
also requires additional capital expenditures. Buffett figures that if sales
double, more dollars will have to be invested in inventory to support these
sales. Fixed assets may respond more slowly than inventory when confronted
by inflation, but eventually, plant and machinery will be replaced with
higher cost equipment.
Since See's had only $8 million in assets producing $2 million in earnings,
to reach $4 million in earnings would require it to commit another $8
million in capital. Bee's on the other hand, would require $18 million in
capital to generate an additional $2 million in earnings. Bee's now
generates $4 million in earnings on $36 million in assets. Still earning 11
percent on capital, Bee's would sell for approximately $36 million. Hence
Bee's owners have created one dollar of market value for every one dollar of
invested capital. See's now generating $4 million on $16 million of capital,
logically would be worth $50 million. See's Buffett points out, gained $25
million in market value by investing only $8 million in capital, or over
three dollars for every one dollar invested.

I could have mailed this to you directly but thought it was interesting to
bring up some comment on the forum.

This has become very relevant in many of todays businesses. BCH, ADV, RMG,
RNS etc
and we can certainly recognise businesses like Bee's on the NZSE, FFS, CAH
etc.

In regards to companies like RMG, the returns based on purchase price are
real and these "intangables" are producing cash flows (all cash flow
positive) and of course are very real, economic goodwill is nothing to hide
from if it is returning good earnings and has a lower capital base to
maintain.....hence the returns at BCH and the valuations given to it.

Good support in Aus for RMG from 18-24c in last week.

R
Warner








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