How can you gauge how innovate a company truly is? Is there a metric that comprehensively measures the innovative capacity of a company? It’s a loaded question, I know.
There are many ways analysts look at the innovation that comes from within a company using their spreadsheets as lorgnettes, but none of the metrics alone answer the question. You can look at cash flows from investing activities to see what assets a company is purchasing to develop future products. You can look at revenue and income growth, which encompass the affects of innovative products and services. Or you can take the holistic view and see how the actual products and services compare to those of competitors (is the Apple Watch innovative compared to the Pebble, Galaxy Gear?). There are probably hundreds of other metrics you can look at, but watch out, don’t get bit by analysis paralysis.
I decided to take a different approach to gauge the innovation index of a company - one you will not find in textbooks. My approach is simple (Excel bravura seems to be a major trend among analysts. I’m a strong believer the less complexity your financial models contain, the more accurate they are). I’m looking at goodwill on the companies balance sheets and the age of the company. Divide goodwill by age (in days), and you get goodwill acquired per day. The higher the goodwill per day, the more acquisitions a company engaged in over the years. Usually, acquisitions mean external innovation rather than internal innovation, since by definition you are hiring people from outside your company.
If you’re not aware of what goodwill is, don’t worry, we will cover that now. When a company buys another company, they will often pay a premium for the other company. In short, that premium is goodwill. The accounting behind goodwill is rather complex, but I think an example will greatly simplify the idea for you. When Apple acquired Beats, they paid $2.6B for the company. Of this, $2.2B was goodwill. Try to imagine the assets of Beats. They might of had some cash on hand, maybe some accounts receivable, some office space, a few company cars, and a bunch of headphone inventory. They probably also had a good amount of debts in the form of accounts and notes payable. If you add all of the assets, and subtract the liabilities, do you think Beats would be worth $2.6B? Of course not! In other words, Apple paid $2.6B for something that is worth around $400M (net of liabilities). In accounting, everything has to balance. The difference between the price you paid ($2.6B) and the net price Beats is worth ($400M) is goodwill. In this case, Apple added $2.2B ($2.6B - $400M) of goodwill to its books. For the accountants reading, I know this is a gross simplification of goodwill calculations, but work with me here!
So why does goodwill matter? Well, because it’s essentially external innovation. You purchase innovative, external companies to generate income for you in the future instead of generating it internally with your own employees. There’s nothing wrong with that. In fact, acquisitions are a way of life in some industries. But it’s always better to innovate from within when you can. Normally, older companies tend to start amassing goodwill as they become more bureaucratic, larger, and as a result much slower to innovate. In contrast, younger companies are less bureaucratic, much smaller, and can move fast and break things more easily. They also tend to have much less cash on hand to make the acquisitions in the first place. With all that out of the way, let’s take a look at a few goodwill charts using my simple method.
For the chart above, I picked a few well-known companies to see how much goodwill they carry on their books. As you can see, IBM and Microsoft lead the way. IBM has been around in some way or another for over a hundred years, so it’s no wonder their goodwill is almost $30B (goodwill can be “impaired” and written off the books, so this $30B is everything that wasn’t written off over the years). Similarly, Microsoft and Intel also accumulated high amounts of goodwill over the years as a result of many acquisitions. Unlike the ancient tech giants, however, Facebook has not been around for decades, and yet it leads the pack in goodwill. This is mostly due to the WhatsApp acquisition, which contained $15.3B of goodwill. It’s also worth pointing out that neither Tesla nor Netflix have any goodwill, which is because they haven’t purchased any companies. In other words, all of their innovation comes from within the company. Finally, look how low the goodwill of Apple is, despite it being older than Microsoft (more on that later).
This chart is where the interesting stuff begins to appear. The simple goodwill metric I was talking about it evidenced here. While it’s by no means a perfect metric (all metrics have flaws), it attempts to show how much innovation is developed internally versus externally. Goodwill is displayed by the light blue line, while Days Since IPO is shown on the navy bar chart. As you can tell, IBM has been around the longest, and also has the highest amount of goodwill. Next on the list is Microsoft, which is relatively old, but has goodwill that is disproportionately higher to its age (look how much higher goodwill is compared to the age of the company). Intel developed most of its technology internally, since the light blue goodwill line is inside the Days Since IPO bar. I won’t detail every company on the chart, but here are some the caught my eye.
Amazon develops most of its stuff in-house. Relative to the age of the company, Amazon’s goodwill isn’t too high, which means that Amazon hasn’t made many acquisitions. Google has goodwill that is higher than the age of the company, which tells us a lot innovations made by Google were purchased from external companies. For a large and old company, Apple has a remarkably low amount of goodwill. Crazy low, in fact (it would be even lower before the Beats acquisition, which was one of the largest goodwill acquisitions Apple has ever made). In English, we know this means that almost all of Apple’s products and services are developed internally without the help of external purchases. Since its IPO in 1980, Apple has been able to innovate incredibly well. Facebook, by stark contrast, has a goodwill that is literally off the charts, compared to its age. Of course, this is mostly because of one major purchase (two if you count Instagram). Since Facebook is such a young company, it is too early to tell how innovative it is internally, but the data so far suggests it is not.
There isn’t much to say about this chart other than it’s interesting, but not as insightful as the previous two charts. I divided the total goodwill of each company by its age to get Goodwill Acquired Per Day. Again, look how small Apple’s goodwill compares to the other tech giants (IBM, Microsoft, Intel, and Google).
Finally, I took the goodwill and divided it by the total assets of each company. While this is a deeply flawed metric, it does attempt to communicate a powerful point: the percentage is how much a company relies on external innovation (see the caveat emptor below for more disclosures before relying too heavily on these metrics). 43% of Facebook’s assets are goodwill - crazy! In contrast, only 2% of Apple’s assets are goodwill.
What I like about these goodwill charts is that they confirmed what I always suspected. It’s best to compare the companies as a cohort. IBM is in its own cohort because it’s by far the oldest company. Intel, Microsoft, and Apple are the next oldest cohort. All of the other companies are the third, and youngest cohort. Feel free to make as many cohorts as you like - my only advice is to make a cohort in the first place because it would be foolish to compare IBM to Facebook (IBM has over 100 years on Facebook!). Just to provide an example of how this could be done, let’s take the second cohort of Intel, Microsoft, and Apple. Their goodwill as a percentage of total assets is as follows: Intel 12%, Microsoft 12%, Apple 2%. Judging by the much lower percentage Apple holds, you can draw the conclusion that Apple makes less acquisitions and thus develops more innovations internally. Intel and Microsoft, on the other hand, are just about equal in their reliance on external acquisitions. If you want to beef this metric up, I would even recommend you make a historical comparison of goodwill for these companies just to see how write-downs have impacted goodwill over the years.
Before any critics start commenting on this post, allow me to point out the major flaws of this goodwill metric. First, it uses goodwill as of the most recent balance sheet date. This means that if any goodwill was written off in prior periods, the charts above will not factor that in. Next, there is no weighting for the age of the companies. It would be most interesting to compare all of the companies as if they were the same age (Apple at 2 years old, Microsoft at 2 years old, Facebook at 2 years old, etc) so that we see how goodwill compares relative to the age of each company. I wasn’t able to find financial records dating that far back for the older companies, granted I only checked EDGAR archives and could probably find them with more time (perhaps in a future post). More caveats still - goodwill can be the result of overpayment. Finally, it’s a valid argument that goodwill does not imply a company is not able to innovate internally. Perhaps a company with a large amount of goodwill acquired many companies, but nothing innovative came out of them, and instead, the innovation came internally. This is entirely possible, but I cannot measure that in a spreadsheet. There are many more flaws to this metric, but it still gives us an interesting look into goodwill. I recommend adding it to your arsenal of metrics to gauge a company by.