Eaton (NYS: ETN) carries $8.1 billion of goodwill and other intangibles on its balance sheet. Sometimes goodwill, especially when it's excessive, can foreshadow problems down the road. Could this be the case with Eaton?
Before we answer that, let's look at what could go wrong.
AOL blows up
In early 2002, AOL Time Warner was trading for $66.27 per share.
It had $209 billion of assets on its balance sheet, and $128 billion of that was in the form of goodwill and other intangible assets. Goodwill is simply the difference between the price paid for a company during an acquisition and the net assets of the acquired company. The $128 billion of goodwill in this case was created when AOL and Time Warner merged in 2000.
The problem with inflating your net assets with goodwill is that it can -- being intangible after all -- go away if the acquisition or merger doesn't create the amount of value that was expected. That's what happened in AOL Time Warner's case. It had to write off most of the goodwill over the next few months, and one year later that line item had shrunk to $37 billion. Investors punished the stock along the way, sending it down to $27.04 -- or nearly a 60% loss.
In his fine book It's Earnings That Count, Hewitt Heiserman explains the AOL situation and how two simple metrics can help minimize your risk of owning a company that may blow up like this. Let's see how Eaton holds up using his two metrics.
Intangible assets ratio
This ratio shows us the percentage of total assets made up by goodwill and other intangibles. Heiserman says he views anything over 20% as worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."
Eaton has an intangible assets ratio of 45%.
This is well above Heiserman's threshold, and you should keep a close eye on just how the company is fueling its growth. It's also useful to compare it to tangible book value, which I explain below.
Tangible book value
Tangible book value is simply what remains after subtracting goodwill and other intangibles from shareholders' equity (also known as book value). If this is not a positive value, Heiserman advises you to run away because such companies may "lack the balance sheet muscle to protect themselves in a recession or from better-financed competitors."
Eaton's tangible book value is $69 million, so no yellow flags here.
By the way, I asked Heiserman about the tendency for some large cap blue chips -- names like Procter & Gamble, IBM, and Altria -- to have a high intangible assets ratio and negative tangible book value. He says this can be OK, provided the company has 1) modest or no net debt, 2) persistent and rising levels of free cash flow, and 3) stock buybacks at a discount to intrinsic value.
Foolish bottom line
To recap, here are Eaton's numbers, as well as a bonus look at a few other companies in its industry:
ITT (NYS: ITT)
Johnson Controls (NYS: JCI)
Parker Hannifin (NYS: PH)
Data provided by Capital IQ, a division of Standard & Poor's.
If you own Eaton, or any other company that fails one of these checks, make sure you understand the business model and management's objectives. You can never base an entire investment thesis on one or two metrics, but there is a yellow flag here. I'll help you keep a close eye on these ratios over the next few quarters by updating them soon after each earnings report.
At the time thisarticle was published Fool analyst Rex Moore owns shares of Procter & Gamble, but no other companies mentioned in this article. The Motley Fool owns shares of Altria Group and International Business Machines. Motley Fool newsletter services have recommended buying shares of Procter & Gamble.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.