This post follows on from You Don’t Need To Be Warren Buffett To Understand Goodwill And Intangibles part 1 by looking at how companies value goodwill and how they explain what goodwill is in the notes to their accounts.
Today’s post will review why you should remove goodwill and intangibles from the valuation of a company like Ben Graham and Walter Schloss.
We will look at the balance sheets of two UK companies.
To begin looking for companies that may turn out to be undervalued, some value orientated fund managers and investors use a list of 52 week lows.
52 week lows is a list companies whose share prices have fallen below the lowest price of the previous twelve months.
A list of 52 week lows matters to value investors because the share prices of companies that have fallen so low could mean that they are undervalued.
I obtained today’s list of 52 week lows from the Morningstar website on 25 June 2012 from which I chose the two companies below.
Company #1: Aquarius Platinum
Here is their consolidated balance sheet from the 3rd quarterly report dated 31 March 2012, from their website:
The 6th item under the heading assets is where you will find intangibles and note v (5). Note 5 in the accounts will explain what intangibles are.
I have reproduced note 5 to the accounts below:
Includes intangibles relating to contract value acquired on the acquisition of equity interest in Platinum Mile Resources (Pty) Ltd.
Aquarius Platinum: The Verdict
Three things struck me about the Platinum Mile acquisition:
- During my subsequent 20 minute search to find more free and publicly available details about the contract value Aquarius acquired with the purchase of Platinum Mile, I found nothing, not even in the notes to the last annual report or four previous quarterly reports.
- Management have decided to remain tight lipped about the contract value which is an immediate red flag: managements who are not forthcoming with prudent financial information should be treated with scepticism and so should the accounts. Details of goodwill and intangible assets are prudent financial information.
- Because there are no details at all about the contract value and therefore intangibles, I am not in a position to calculate a value for it.
The only logical conclusion is to apply a zero value to intangibles at this stage.
Perhaps the management will explain more about their aqcuisition of Platinum Mile in the future but right now, based on the lack of disclosure, I am unable to value goodwill and intangibles.
Company #2: Lonrho
The consolidated balance sheet from the Lonrho annual report dated 31 December 2011:
Goodwill write downs is a naughty practice by managements who fritter away their past mistakes of buying businesses above book value and then writing it off in later years.
The post ‘Do You Make This Classic Investing Mistake?’ delves deeper into Microsoft’s writing off of goodwill.
Lonrho: The Verdict
Lonhro’s notes to the accounts contained this pertinent statement in regard to where the previous years’ goodwill may have come from:
During the period the Group continued its strategy of identifying bolt-on acquisitions which complement its existing business models
So Lonhro likes to acquire businesses above their book value and add goodwill to their own balance sheet.
Intangibles are made up of:
- development costs
- customer relationships
- intellectual property
- contractual rights and licences
According to the management of Lonhro, they are worth £21.9 million; I have no way of accurately valuing these items in a rational, realistic way.
The only logical conclusion is to assign them a zero value.
Why not assign a zero value to other items on the balance sheet?
As we saw in You Don’t Need To Be Warren Buffett To Understand Goodwill And Intangibles – Part 1, things like property (houses/land), plant (machinery/conveyor belts) and equipment (computers, fax machines, chairs, desks, phones) are physical items that can be more readily valued, especially if you know how old they are.
For example cash or land (tangibles) is far easier to value than a licence or customer relationships (intangibles).
Lonhro state in their notes to accounts that their assets – excluding goodwill and intangibles – are made up of long leasehold land and buildings, short leasehold land and buildings, plant and machinery, fixtures and fittings and aircraft.
In the absence of double checking the valuations management provide for assets, as a value investor, I make allowances for my own and managements assessment of tangible assets by purchasing companies at or below book value.
This means that if I am wrong or management have distorted the truth about the valuations of their tangible assets, then I am protected from my own and managements short comings by buying companies at a discount from their tangible value.
My hope with this two part series of posts was to briefly introduce goodwill and intangibles and the reasons why I remove them from the valuation of a business. Ben Graham and Walter Schloss both practised this which is why it has become part of the investment strategy of The Shares And Stock Markets Blog.
Do you include goodwill during the valuation process?
Thanks for reading The Shares and Stock Markets Blog. Good luck with your investments.
Disclosure: I do not hold any positions at the time of writing in any of the companies mentioned in this post.
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