Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 29

Wipeout – the problem with goodwill

Billabong’s recent ‘big bath’ writedown marked yet another arguable example of hubris and investor loss by a major Australian company. It is worthwhile examining the investment merits of analysing balance sheets with the express intention of avoiding the permanent capital impairment that occurs with corporate writedowns.

Australia corporate graveyards are quite literally filled with the detritus of past attempts at greatness, where management’s actions exceeded their abilities and where ‘synergistic’ corporate kisses fell flat. For long-term investors in companies that suffer from being managed by such lauded corporate chieftains, time is an enemy that robs wealth. More importantly, clichés about investing for the long term are inappropriate at best and downright irresponsible at worst.

The dreaded ‘earnings update’ with a goodwill writedown

Companies regularly make announcements that may be hopeful and promotional or confessional and reluctant but it is the ‘earnings update’ containing a writedown that fires me up. This is where so many Australian companies have dashed their owner’s retirement dreams and hopes for financial independence.

In the 12 months to 30 June 2009 – admittedly the GFC was reaching its nadir - Australian companies wrote off, took a bath on, drew a line through or just plain old destroyed $47 billion dollars. And that was on top of $16 billion in writedowns the previous year. In 2010 Asciano took a $1.1 billion bath. In 2013 it was Billabong’s turn to make a writedown three times larger than its total market value. The result was affected by $867 million in significant items, including more than $604 million in writedowns in the value of goodwill, brands and other intangibles. It also included a $129 million writedown as a result of transactions involving US brand Nixon.

It’s the so-called ‘goodwill’ that I would like to examine today. A business is worth much more than its net tangible assets when it produces profits well in excess of market-wide rates of return. When this transpires the company is said to have economic goodwill.

A company’s book value is its net worth.  Book value is made up of tangible assets and intangible assets. Tangible assets are physical and financial and include property, plant and equipment, inventory, cash, receivables and investments. Intangible assets aren’t physical or financial. These are trademarks, copyrights, franchises, patents and accounting goodwill.

Tangible and intangible assets

I have earned a bit of a reputation for warning investors about capital intensity, particularly with respect to investments in airlines. When it comes to physical assets, less is more. For a business to double sales and profits, there is frequently the requirement to increase the level of assets to produce those increased sales and profits. The higher the proportion of physical assets compared to sales that are required, the less cash flow available to the owner. This is the antithesis of the intangible-heavy business that continually produces profits without the need to spend money on maintenance, upgrades or replacements.

Take two companies Rich Pty Limited and Poor Pty Limited. Both companies earn a profit of $100,000. Rich Pty Limited has net assets of $1 million. Intangible assets, such as patents and a brand, represent $600,000 while physical assets including machinery running at full capacity and inventory represent $400,000. Poor Pty Limited also has a net worth of $1 million, but this time the intangible/intangible mix is reversed. Tangible assets are $800,000 and $200,000 is intangible.

Rich P/L is earning $100,000 from tangible assets of $400,000 and Poor P/L is earning $100,000 from tangible assets of $800,000. If both companies sought to double earnings, they might have to also double their investment in tangible assets. Rich P/L would have to invest another $400,000 to increase earnings by $100,000. Poor P/L would have to spend another $800,000.

For many investors a large proportion of physical assets – also reflected in a high Net Tangible Assets – was seen as a solid backstop in the event something catastrophic should befall a company. The opposite may be true. A high level of physical assets may be a drag on returns. Physical assets are only worth more if they can generate a higher rate of earnings. Any hope that they are worth more than their book value is based on the ability to sell them for more, and that, in turn, is dependent on either finding a ‘sucker’ to buy them or a buyer who can generate a much higher return and therefore justify the high price.

But while a high level of tangible assets producing low returns can suggest the tangible assets are overvalued, so too a high level of intangibles assets – particularly accounting goodwill – combined with low returns, can suggest a write down is in order.

Accounting goodwill is not economic goodwill

Back in December 2006, Toll announced the separation of its logistics business from its infrastructure and port assets. This was not a requirement of the ACCC who had asked Toll to merely divest 50% of its stake in Pacific Rail. Nevertheless, Asciano was born – its head was Mark Rowthorn, Paul Little’s deputy and son of former Toll chairman Peter Rowsthorn. Its balance sheet would be dominated by $4.5 billion of debt, $2.3 billion of property, plant and equipment (PP&E) and $4.2 billion of accounting goodwill – what I think the auditors should rename ‘Oops-I-paid-too-much’ before adding it to the balance sheet.

Wouldn’t it be nice if we could all just add a few hundred million of goodwill to our own personal balance sheets before we headed down to the bank for a loan? You see, accounting goodwill is not economic goodwill.

Under the restructure Toll shareholders received a fully franked dividend that was compulsorily applied to subscribe for Asciano units. While this was another non-cash transaction it had the effect of ascribing a value. Asciano’s goodwill was inherited as part of the split that saw Toll shareholders retain one Toll share and receive an Asciano Stapled Security. The market (in its great wisdom) ascribed a value of $10.76 per security for Asciano on its debut, giving the company a market value of $6.8 billion. The net assets were $2.9 billion and net tangible assets were negative.

Would you pay $680,000 for a house and mortgage ‘package’ that comprised equity of $290,000? You would only if the profits the house was generating produced a decent return on the $680,000. Assuming an after tax return of, say 12%, the house would need to produce a profit after tax of $81,600. Turn the thousands into millions and that means, paying $6.8 billion you would need Asciano to produce an after tax profit of $816 million –a figure that has thus far not been achieved. Unsurprisingly, in the interim, Asciano had its own big bath writedown.

What’s happened since 2011?

With these ideas in mind, it may worth going back in time and looking at a list of companies that may have had very high levels of tangible assets compared to their profits. Indeed we may as well also throw in those companies that might have had highly valued intangible assets too. If they were generating low returns on these assets, as for example, Billabong and Fairfax have been recently, the auditors should arguably have taken a knife to their stated ‘book’ values. This is precisely what happened at Fairfax some time ago and more recently at Billabong.

But if high levels of intangibles are not written down by the auditors – even after years of generating mediocre returns – the market will often do the writing down for them. Either way, shareholders receive lousy returns.

Let’s go back in time to 2011 and see what has happened since. Starting with the 156 companies with a market capitalisation of more than $1 billion, I ranked them by return on equity (return on book value) in ascending order and there were 49 companies generating returns less than a bank term deposit. The biggest 17 are presented below and I have excluded resource companies for while there are plenty that qualify, their returns are dependent on commodity prices.

Companies with either possible high levels of tangible assets or possibly overstated intangible assets carried on the balance sheet in 2011 include:

And what has happened to the value of a hypothetical portfolio invested in the above shares since?   You will not be surprised that the market, in aggregate, has done a pretty good job on both an absolute and relative basis, of ‘writing them off’.

 

Roger Montgomery is the author of value investing best-seller, Value.able, and the Chief Investment Officer at The Montgomery Fund.

 

  •   29 August 2013
  •      
  •   

 

Leave a Comment:

banner

Most viewed in recent weeks

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Family trusts: Are they still worth it?

Family trusts remain a core structure for wealth management, but rising ATO scrutiny and complex compliance raise questions about their ongoing value. Are the benefits still worth the administrative burden?

13 ways to save money on your tax - legally

Thoughtful tax planning is a cornerstone of successful investing. This highlights 13 legal ways that you can reduce tax, preserve capital, and enhance long-term wealth across super, property, and shares.

Warren Buffett's final lesson

I’ve long seen Buffett as a flawed genius: a great investor though a man with shortcomings. With his final letter to Berkshire shareholders, I reflect on how my views of Buffett have changed and the legacy he leaves.

Latest Updates

Retirement

Why it’s time to ditch the retirement journey

Retirement isn’t a clean financial arc. Income shocks, health costs and family pressures hit at random, exposing the limits of age-based planning and the myth of a predictable “retirement journey".

Financial planning

How much does it really cost to raise a child?

With fertility rates at a record low, many say young people aren’t having kids because they’re too expensive. Turns out, it’s not that simple and there are likely other factors at play.

Exchange traded products

Passive ETF investors may be in for a rude shock

Passive ETFs have become wildly popular just as markets, especially the US, reach extreme valuations. For long-term investors, these ETFs make sense, though if you're investing in them to chase performance, look out below.

Shares

Bank reporting season scorecard November 2025

The Big Four banks shrugged off doomsayers with their recent results, posting low loan losses, solid margins, and rising dividends. It underscores their resilience, but lofty valuations mean it’s time to be selective. 

Investment strategies

The real winners from the AI rush

AI is booming, but like the 19th-century gold rush, the real profits may go to those supplying the tools and energy, not the companies at the centre of the rush.

Economy

Why economic forecasts are rarely right (but we still need them)

Economic experts, including the RBA, get plenty of forecasts wrong, but that doesn't make such forecasts worthless. The key isn't to predict perfectly – it's to understand the range of possibilities and plan accordingly.

Strategy

13 reflections on wealth and philanthropy

Wealth keeps growing, yet few ask “how much is enough?” or what their kids truly need. After 23 years in philanthropy, I’ve seen how unexamined wealth can limit impact, and why Australia needs a stronger giving culture.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.