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Strategies & Market Trends : Buffettology -- Ignore unavailable to you. Want to Upgrade?

To: Michael Burry who wrote (1586)	6/9/1999 5:54:00 PM
From: Daniel Chisholm	Read Replies (1) \| Respond to of 4691

Some really thoughtful postings on goodwill accounting, thanks guys! I think it's easy to ridicule the GAAP approach to goodwill, of simply writing it off over a period of time. Such a method is rarely likely to give a true picture -- if the goodwill isn't, then it should perhaps be charged off quicker. If the goodwill represents permanent value, or even better growing intangible value, then we shouldn't be writing it off at all (or marking it up?). Here's an idea that I've been kicking around while I read the recent postings here. "Earnings" ought to represent the true economic value being generated from an enterprise (i.e., free cash flow), to be distinguished from capital flows (return of or addition to capital invested). When we do things such as adding back noncash depreciation, subtracting out maintenance capex, that is what we are really trying to do. If we consistently overstate or understate "earnings" over time, we get into a situation where the enterprises accounting book value becomes increasingly distorted. Unusually (unrealistically) high ROE results from a period of chronic understatement of earnings (i.e., book value is overdepreciated relative to economic reality), unrealistically low ROE results from a period of overstating earnings (e.g., steel mills in an inflationary environment). What if we were to treat this problem as follows. - Establish a benchmark ROE, based on historic free cash flows, best guess, etc. The idea here is not to be super-precise, but to have an idea of what the company is rationally capable of earning. If a substantially lower or higher ROE is indicated, that might cast doubt on either the "E" or the "b.v." used - See how your best guess of "free cash flow" for the current year compares to the company's book value. If this results in an ROE higher than the benchmark, then perhaps what has happened is that the intangible value of the business has grown. - Compute a non-cash "intangible franchise value growth" figure. This is meant to be a noncash item that will be added to free cash flow, and also to book value. Earnings* = Free Cash Flow + Intangible Capital Gain Book Value = Book Value (last year) + Earnings* ROE = Earnings*/Book Value The idea is to set the size of this "intangible capital gain" such that ROE is in the neighborhood of what you expect. This would be an implicit equation to solve, I realize. What I'm trying to get at is to avoid producing unrealistically high ROEs that are meaningless. If a company has created real value, even though it is intangible, we should find a way to account for it. Give management praise an recognition for creating intangible value. And then, hold management responsible for these non-cash earnings - i.e., it becomes part of the equity, and they must earn a decent (realistic) return on this larger valued equity. Comments? - Daniel

To: Michael Burry who wrote (1586)	6/10/1999 1:28:00 AM
From: James Clarke	Read Replies (3) \| Respond to of 4691

Sorry Mike, but I'm with Twister on this one. Forget Mattel, this is a crucial accounting issue and one I have thought about long and hard. If you really want to get at the profitablitity of a business, just get rid of goodwill. Take the goodwill off the balance sheet and add back the amortization to earnings. As Twister's analogy to an individual investor's accounting showed, it is a non-economic issue, so throw it out. <<For a recent acquisition, by purchase accounting, hasn't the net worth on a per share basis already been reduced by the amount added by the acquisition - the equilibrating factor being goodwill?>> No - goodwill is an asset. What Twister and I are saying is that you have to take that asset out to get to the true profitability of the business. Now we get back to Mattel. All I am trying to do is look at Mattel's economics before the acquisition and value the company. I get to about $31 a share and that is a growing number. Then recognize that they just made a big acquisition. Was that dilutive? Maybe. So subtract something from that $31 a share. Was it dilutive by more than $3 a share? I don't think so.