FOOL SCHOOL
Valuation: ROE and Goodwill

January 18, 2002

In the last article we looked at the basics of the Return on Equity (ROE) calculation. Here we introduce the complication of goodwill, an accounting adjustment that occurs whenever one company buys another.

Let's use the same example, Ally's Abode. Say another company sees potential in Ally's one house business and offers to buy it at the end of year 1 for £200,000 cash. Ally thinks this is a pretty good deal, since he bought it for £150,000 and has retained £12,000 in the business, and quickly accepts the offer.

The new buyer, Bernie, thinks the house business is worth £200,000 to him, even though its book value is only £162,000. The fair value of the house, as determined by an independent surveyor, is £170,000. Bernie plans to subdivide the house, add a few more bedrooms and a few more students and receive £20,000 income per annum after tax. His ROE would be 10% (Net income of £20,000/Shareholders' equity of £200,000). Sounds simple. The transaction would be shown in the acquirer's (Bernie's) balance sheet as:

Assets
One House            170,000

Shareholders' Equity
Share Capital        200,000
Purchased Goodwill   (30,000)
                     -------
                     170,000

Note that the book value of £162,000 is completely irrelevant when a business is acquired, as far as the accounts are concerned. Calculating the ROE using net income divided by starting shareholders' equity as stated above gives us an ROE of 11.8% (£20,000/£170,000), much different from the 10% we calculated based on the £200,000 purchase price. The difference all comes down to how you treat the purchased goodwill, which in this example appears in the balance sheet as a reduction in shareholders' equity.

Common sense says that the acquirer's ROE is 10%. Up until 1998, Generally Accepted Accounting Practices (GAAP) allowed UK companies to treat purchased goodwill as in the above example. To calculate the true ROE, a better definition would be:

                 Net Profit
--------------------------------------------
 Shareholders' Equity + Purchased Goodwill

      20,000
------------------ = 0.10 or 10%.
 170,000 + 30,000

Just to confuse things further, from the beginning of 1999, a new accounting Financial Reporting Standard (FRS10) directive came into force. The company can amortise (or write off against profits) it in equal instalments over a period of 20 or more years, or it can choose not to write it off at all. This latter policy can only be followed if an annual impairment test shows that the value of the purchased goodwill hasn't fallen below the level it is being carried at in the balance sheet. Confused? It basically means that the same balance sheet as above would probably look like this when the accountants comply with FRS10:

Assets
One House             170,000
Goodwill               30,000
                      -------
Total Assets          200,000

Shareholders' Equity
Total Share Capital   200,000

At least that makes ROE far easier to calculate, and makes much better sense than writing off goodwill against shareholders' equity. Examples like this show just what confusing and even ambiguous accounting practises can mean to what should be a simple ratio calculation. Investors should always attempt to look through the mumbo-jumbo and try to visualise any company's performance as if it were their own. In conclusion, ROE is effectively a measure of the efficiency with which a company employs shareholders' capital. It is also a measure of the percentage return to owners on their investment. In the next article we'll look at how we can use the ROE figure.

Other valuation articles:
The PE ratio
The PEG ratio
Price to Sales
Dividend Yield
Return on Equity
Uses of Return on Equity
Balance Sheet Basics
Discounted Cash Flow