Office Depot (NYS: ODP) carries $98.4 million 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 Office Depot?
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 Office Depot 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."
Office Depot has an intangible assets ratio of 2%. This is well below Heiserman's threshold, and a sign that any growth you see with the company is probably organic. But we're not through; let's also take a look at tangible book value.
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 avoid the company because it may "lack the balance sheet muscle to protect [itself] in a recession or from better-financed competitors."
Office Depot's tangible book value is $647.5 million, so no yellow flags here.
Foolish bottom line
To recap, here are Office Depot's numbers, as well as a bonus look at a few other companies in its industry.
Intangible Assets Ratio
Tangible Book Value (Millions)
OfficeMax (NYS: OMX)
Staples (NAS: SPLS)
Wal-Mart Stores (NYS: WMT)
Data provided by S&P Capital IQ.
Office Depot appears to be in good shape in terms of the intangible assets ratio and tangible book value. You can never base an entire investment thesis on one or two metrics, but there are no yellow flags here. If any companies you're researching do fail one of these checks, make sure you understand the business model and management's objectives. I'll help you keep a close eye on these ratios over the next few quarters by updating them soon after each earnings report. To stay current on any developments at these companies, I encourage you to add these companies to My Watchlist. My Watchlist is a totally free service offered by The Motley Fool to keep you updated on all the relevant news and events about the companies you're interested in. Click here to start today.
At the time thisarticle was published Fool analystRex Mooreowns no companies mentioned in this article. The Motley Fool owns shares of Wal-Mart Stores.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart Stores and Staples and creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.