The Essays of Warren Buffett: Lessons for Corporate America

by Warren Buffett

Accounting goodwill is essentially the amount by which the purchase price of a business exceeds the fair value of the assets acquired (after deducting liabilities). It is recorded as an asset on the balance sheet and then amortized as an annual expense, usually over forty years. So the accounting goodwill assigned to that business decreases over time by the aggregate amount of that expense. Economic goodwill is something else. It is the combination of intangible assets, like brand name recognition, that enable a business to produce earnings on tangible assets, like plant and equipment, in excess of average rates. The amount of economic goodwill is the capitalized value of that excess. Economic goodwill tends to increase over time, at least nominally in proportion to inflation for mediocre businesses, and more than that for businesses with solid economic or franchise characteristics. Indeed, businesses with more economic goodwill relative to tangible assets are hurt far less by inflation than businesses with less of that. These differences between accounting goodwill and economic goodwill entail the following insights. First, the best guide to the value of a business's economic goodwill is what it can earn on unleveraged net tangible assets, excluding charges for amortization of goodwill. Therefore when a business acquires other businesses, and the acquisitions are reflected in an asset account called goodwill, analysis of that business should ignore the amortization charge...