Return On Capital – Difference Between ROC Including Or Excluding Goodwill

A question for you.

Two companies in the same industry, but with different return on equity (ROE), with Company 1 having higher ROE in general than Company 2, per the chart below. Which one would you prefer to own?

Now, what if I tell you, in calculating the ROE figures, if we exclude the amount of goodwill from the equity amount, then Company 2 would now have higher ROE figures, per the chart below (the dotted lines)? Would you change your mind?

If you are not familiar with the concept of return on capital (ROC), including or excluding goodwill amount, then you might be a bit confused now.

But don’t worry. Let’s debunk this for you today, by:

• starting with explaining what is goodwill;

• looking at actual examples of companies that have very different ROEs including or excluding goodwill, and see what that means for us investors; and

• revisiting our question above (on Company 1 vs Company 2), and see how we can think about it with our latest understanding.

Understanding Goodwill

So, what’s goodwill?

You would probably have seen this in the balance sheet of many companies.

Basically, goodwill is an intangible asset that arises when a company acquires another entire business. 

Basically, when a company acquires another business, most of the time, the price it pays to purchase the business is higher than the fair market value of all of the assets purchased in the acquisition (including both tangible assets and intangible assets that can be identified) and the liabilities assumed in the process.

Goodwill is an intangible asset that is recognised when this happens, and it’s calculated as the difference between the purchase price and the net fair market value of the assets & liabilities assumed.

And the value of that goodwill premium paid is usually reported as paying for a company’s name, brand reputation, loyal customer base, solid customer service, good employee relations, and proprietary technology, or synergies that would be achieved from the acquisition etc.

Let’s have a look at one example – Evolution, a Swedish gaming company. 

Evolution used to have no goodwill on its balance sheet, until the year 2019.

In 2019, it acquired another gaming provider, Ezugi, for a total consideration of EUR 16.0 million. 

However, as shown in the screenshot below (of a note in Evolution’s annual report), it valued the net assets acquired at only EUR 3.5 million (= EUR 5.9 million of assets, minus EUR 2.3 million of liabilities).

Thus, effectively, it paid a premium of EUR 12.4 million over the fair value of the net assets, which it recorded as goodwill, which it attributed to “expected profitability, employee know-how and expected synergy effects”.

The next year, in 2020, it made another acquisition, a very large acquisition of another gaming company NetEnt, for EUR 2.3 billion, in a share swap transaction. Per screenshot below, that purchase consideration exceeded the fair value of acquired net assets of EUR 0.5 billion, by EUR 1.8 billion, which it added to its existing goodwill amount.

Due to this large acquisition, Evolution’s total goodwill amount shot up to EUR 1.8 billion in 2020. This was a large amount (67%) relative to its book equity amount of EUR 2.7 billion at the end of 2020, which had shot up too from EUR 0.3 billion in the previous year (together with an increase in outstanding shares, due to new shares issued).

Thus, whether we include or exclude goodwill amount in the equity amount used for the calculation of ROE, has a huge impact on the numbers, as we will see below.

ROE including or excluding goodwill

Now, let’s look at Evolution’s ROE figures, both including and excluding goodwill amount in the equity amount.

As seen in the chart below, Evolution has been reinvesting and increasing its equity (excluding goodwill amount) over time, and because it started having lots of goodwill from 2020 onwards, its total equity (including goodwill amount) shot up during those periods.

Because of the jump in goodwill and total equity (including goodwill) amounts from 2020 onwards, Evolution’s ROE (including goodwill) crashed from 53% in 2019 to 10% in 2020, which then gradually recovered to 24% in 2022 (i.e. two years later).

Meanwhile, its ROE (excluding goodwill) remained more stable, dropping from 56% in 2019 to 32% in 2020, and then recovering to even higher levels, to a high of 74% in 2022.

So, what exactly happened, and how should we interpret these movements? Should we focus more on ROE including or excluding goodwill?

Let’s talk about what the ROE excluding goodwill means first.

As mentioned earlier, in 2020, Evolution paid EUR 2.3 billion to acquire NetEnt, another gaming company, and that company had a net assets (or equity value) of just EUR 0.5 billion.

The EUR 0.5 billion book value for net assets (or equity) for NetEnt means that, to run the operations of NetEnt’s business, the approximate cost of the net assets required was EUR 0.5 billion.

This means that, if Evolution tried to rebuild the exact same business of NetEnt, from scratch organically (instead of acquiring the existing business, at a premium), it would probably cost Evolution just around EUR 0.5 billion of money (and of course, a considerable amount of time), and it would not have to pay for the market premium of EUR 1.8 billion (of goodwill).

The purchase premium (goodwill) paid is one off, and now that Evolution had already acquired NetEnt in 2020, to continue growing the combined business organically from 2021 onwards, the additional capital required would be based on the book value of net assets (i.e. excluding the goodwill amount).

In Evolution’s case, the additional capital (based on book value) deployed to grow the business organically (mainly) in 2021 and 2022 was generating a ROE of 50% or more, based on the ROE figures excluding goodwill.

Which is why, you see the ROE figures including goodwill of Evolution improving sharply in 2021 and 2022 (after the sharp drop to 10% in 2020), because Evolution’s “true” ROE for organic growth was much higher than 10%.

So, the ROE excluding goodwill figures give an idea of the type of return that is achieved by the equity capital, if the business has grown itself organically (instead of through acquisitions).

Hence, the pure return on capital economics of a combined entity (formed from the acquisition of a company by another company) should be evaluated based on the return on capital excluding goodwill, simply because the goodwill amount has not exactly gone into the operations of the business as new capital. The goodwill amount is just the excess amount that the buyer paid the seller, so sometimes, the actual ‘operating quality’ of an acquired business might get unfairly disguised under the goodwill amount.

Meanwhile, the ROE including goodwill figure captures the fact that, if a company has grown through acquisitions, and has paid a premium over the book value of the net assets during those acquisitions, then that acquisitive growth has an extra cost, which is the goodwill amount. This means more capital is required to grow the business, and hence the ROE including goodwill figure is lower than the ROE excluding goodwill figure.

The ROE including goodwill figure also captures the impact of the management’s capital allocation, where if the management overpays a lot for acquisitions, then the company’s ROE including goodwill is “punished” down.

Conclusion

Hence, the inclusion or exclusion of goodwill from the ROE can reveal different aspects of a company’s performance. As investors, it would be wise for us to analyse the ROE in both cases to better understand a business.

While it’s not easy to dig under the bonnet for these numbers (apart from knowing how to interpret these numbers), we’ve made it slightly easier for you through our MoneyWiseSmart courses here.

In fact, Companies 1 & 2 are actual public listed businesses, and we reveal what they actually are in our Principles of Compounding for Bonds & Stocks course.

You can check out the course once it’s released, and let us know if you have any questions or comments about this topic of goodwill!