What To Love About Economic Goodwill


All of this is to say that in trying to get a sense of the capital productivity of a business, or the return on invested capital that a business generates in excess of its cost of capital (i.e., economic profits – more is better) we should look at the return on only tangible assets and therefore exclude goodwill in the denominator.  If that return is high, that means that the business has something special that is generating high returns and that something special consists of intangible assets that really earn. That something special – the “capitalized value” of those juicy economic profits – is economic goodwill.  

A single dollar bill, representing economic goodwill.

3 Things to Love About Economic Goodwill

Here are three  great things about a business with lots of economic goodwill:

First, A business with economic goodwill is far harder to compete with than a business that employs purely tangible assets, because tangible assets can be easily replicated by competitors (i.e, they buy them), while replicating expertise, brands, reputation, exclusive government contracts, scale economies, or the assemblage of intellectual capital that some service business might possess and succeed in retaining, for example, is often far more difficult.  This means returns from economic goodwill rather than tangible assets are more likely to be sustained, which is a critical attribute of businesses that are good investment candidates.  

Second, economic goodwill usually does not require as much maintenance investment – at least via capital expenditures – as tangible asset-intensive businesses. PP&E has a useful life and must be completely replaced over time but a brand or process could potentially last a long time without requiring replacement investment. In fact, putting aside “investment” via sales and marketing in the income statement, a brand can often become more valuable over time without any capital investment, per se.  This is what Buffett is talking about with the See’s brand.  Less investment + more future cash flow = higher economic profits = higher intrinsic value. 

A third aspect, which is related to the second, is that businesses with lots of economic goodwill – which we see via high return on tangible capital – are very well situated for inflation. This is true because while inflation will likely mean the business generates more revenue (i.e., higher selling prices), it will require less capital investment to achieve that revenue than a business that generates the same level of revenue or profits employing all or mostly tangible assets. In other words, it’s insulated from the capital costs that come with price inflation.  Here is how Buffett explains it through a comparison of See’s Candy to a “mundane business”

“…economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in “honest-to-God” assets. Could less really have been more, as our purchase price implied? The answer is “yes” – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.”

Simply put, businesses with high economic goodwill that can be sustained have tremendous tailwinds for growth and durability.  When investors can get economic goodwill without paying too much for it, it really helps investment returns, especially over long periods of time.   

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