re: goodwill
Paul, you've got it. But maybe this is worth expanding on a little because it is a big deal for many companies. Lets use a real example.
When Disney acquired Cap Cities/ABC, they paid $18 billion over book value. I'm not interested in whether they overpaid or not, but it should be obvious that the franchise of ABC is worth more than its book value, signficantly more. Now Disney has an $18 billion asset on its balance sheet called goodwill. It takes a charge to earnings to amortize that goodwill over 40 years, so there is an expense of almost $500 million a year for amortization.
Lets think about that. Its a big number, about 23 cents a share. Without that charge, Disney trades at 22x earnings. With the charge, it trades at about 28x. Big number.
Now what is it? The way I look at it is this. If Disney had not acquired Cap Cities/ABC, that expense would clearly not exist on Disney's income statement. But it is equally clear that it would not exist on ABC's income statement either. So where did it come from? The only economic rationale is that the asset on the balance sheet (which also would not exist anywhere but for the acquisition) is depreciating in value. Is that reasonable? ABC's franchise may indeed be diminishing in value, but the accounting would be the same even if the FCC outlawed cable television tomorrow. The point is that the charge has nothing to do with economic reality, it is a non-cash expense, and it distorts earnings downward. In this case, I would add it back to earnings and base my P/E analysis on that figure.
If you believe this argument, you will be surprised how many companies you find that are much cheaper than they look. Sometimes the market recognizes this, but in my experience I find I can buy real bargains because of this accounting noise which distorts true earning power.
Jim |
