Adobe Systems (NAS: ADBE) carries $4.4 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 Adobe?
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 Adobe 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."
Adobe has an intangible assets ratio of 49%.
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. 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."
Adobe's tangible book value is $1.4 billion, so no yellow flags here.
Foolish bottom line
If you own Adobe, 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.
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At the time thisarticle was published Rex Moore owns none of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Adobe Systems. Motley Fool newsletter services have recommended creating a diagonal call position in Adobe Systems. 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.
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