Accounting Goodwill & Acquired Intangibles ROIC

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Let’s build on the discussion of intangibles generally to get to the answer to this important question: should I include goodwill when calculating return on invested capital?

First, a quick review.

Intangible Assets

There is a wide range of assets businesses use to create value aside from property, plant and equipment, and other hard assets. These are intangible assets, and they are evolving all the time. Thirty years ago the example of a company’s valuable intangible asset that would most easily come to mind would be reputation.  At that time it was hard to imagine that a possibly more valuable intangible asset of a company could be its digital marketing sales funnel expertise, or its CRM database and the way its salesforce configures and exploits it, or its ERP software, or the code and critical mass of buyers and sellers that comprise the company’s unrivaled two-sided marketplace.  Indeed, today every SaaS vertical provides a source of intangible asset customers – that is their product offering at its core. The internet and digitization have massively expanded the realm of intangible assets. 

Accounting Goodwill

This asset type is only present on a company’s balance sheet if an acquisition has taken place. It is the price paid less the sum of identifiable intangible assets (see below) and net asset value.  It is the accountants’ attempt to reflect the value of intangible assets (or something close to it) on the acquirer’s balance sheet. The idea is, if an acquirer paid more than net tangible asset value plus identifiable intangibles (aka book value), there must be a reason – and they are trying to capture the value of that reason on the balance sheet. The same goes for identifiable acquired intangibles (distinguish from internally developed): these assets are created on the balance sheet in an acquisition using measurement methods specified under GAAP.

Here is how McKinsey groups accounting goodwill with acquired intangibles in Valuation, 7th Edition:

“Goodwill and acquired intangibles are intangible assets purchased in an acquisition…In our analysis we treat goodwill identically to acquired intangibles. Therefore, we often shorten the expression goodwill and acquired intangibles to goodwill.”

There is one important distinction between goodwill and identifiable intangibles, and that is that goodwill is not amortized (it is tested for impairment annually) but identifiable intangible assets are amortized. But right now we are focused on the denominator of the ROIC calculation (invested capital), so we will put that issue aside, and going forward I will refer to the sum of accounting goodwill and identifiable intangible assets as “GIIA.”

Include GIIA in Calculating ROIC?

How should we think about GIIA when calculating ROIC? The answer is, you should probably calculate ROIC both with and without goodwill. But if you are interested in evaluating the underlying economics of the business for valuation purposes and not management, you should exclude GIIA in the denominator of the ROIC calculation.


Again, from Valuation, 7th Edition:

“ROIC with goodwill and acquired intangibles measures a company’s ability to create value after paying acquisition premiums. ROIC without goodwill and acquired intangibles measures the competitiveness of the underlying business. When you are analyzing the performance of a company it’s critical to understand ROIC with and without goodwill….The reason to compute ROIC with and without goodwill is that each ratio analyzes different things.  ROIC with goodwill measures whether the company has earned adequate returns for shareholders, factoring in price paid for acquisitions.  

ROIC excluding goodwill measures the underlying operating performance of a company. It tells you whether the underlying economics generate ROIC above the cost of capital. It can be used to compare a company’s performance against that of peers and to analyze trends. It is not affected by the price premiums paid for acquisitions.  

ROIC without goodwill is also more relevant for projecting future cash flows and setting strategy. A company does not need to spend more on acquisitions to grow organically so ROIC without goodwill is a more relevant baseline for forecasting cashflows.  

Finally, companies that have a high ROIC without goodwill will likely create more value from growth, while companies that have low ROIC without goodwill will likely create more value by improving ROIC.”

Here is a different articulation of mostly the same point from two separate sections of Beyond Earnings. Note that they refer to CFROI, a concept I will get to in another post. But for now, just read CFROI as “ROIC.”

“Goodwill is the amount in excess of book value paid for an acquisition.  The goodwill may reflect the value of a brand or a sustainable competitive advantage.  It could also reflect an anticipation of future synergies or the hubris of the acquirer. 

You may have noticed there is no place in the CFROI calculation for goodwill, yet it is on the books and it does reflect an expenditure of shareholder funds…”

“CFROI is designed to measure the economic profitability of the operating business: the cash generated against the cash invested. While goodwill is certainly an expenditure of shareholder funds, it is not recognized as an operating asset...

It is a sunk cost and has no bearing on future operations.”

So there you have it.

Practical Use of ROIC

When I am evaluating stocks as investments I am very interested in their ability to generate economic profits, so I always calculate ROIC both with and without GIIA but focus on the version without GIAA. 

By the way, some may call the minus-GIAA version return on tangible capital, but technically it is not because intangibles that are created other than via acquisition are not backed out with GIAA. But this difference is going to be negligible in most cases, so if Return On Tangible Capital sounds better to you, go for it. 

Sometimes there can be a dramatic difference between ROIC with and without GIIA and of course, it is almost always driven by the level of acquisitions. This presents an interesting issue with respect to screening, since most screeners (including Bloomberg, CapitalIQ) do not exclude goodwill (or GIIA)  in their ROIC calculation, so companies with a lot of it will screen as having lower ROIC than they actually are from the standpoint of prospective economic profitability.

This is also something to keep in mind when quickly comparing two companies using ROIC – if goodwill is not excluded, the company that has done more acquisitions will appear to have (relatively) lower capital productivity even though the economic reality might be quite the opposite. It should also be noted that a company that decides to write down a lot of goodwill will instantly have a higher ROIC than it did the quarter before and that higher ROIC can be a very false signal because it may have no bearing on economic reality.  Beyond Earnings discusses the fact that management teams can attempt to manipulate management comp that is linked to ROC by pushing for large goodwill writedowns, for example. 

Over the years I have learned to get a handle on ROIC early in the process of looking at a stock because if I can’t get excited about prospective ROIC, there simply aren’t going to be many other things about the stock that might make me keep going, so why waste the time. And being ruthless about one’s time is an important part of being a successful securities analyst.  

Next up is economic goodwill, and the inevitable reference to a Berkshire letter.

Please email me with questions/comments/errors related to this post!