Keeping an Eye on Gilead's Intangibles

Gilead Sciences (NAS: GILD) carries $12.8 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 Gilead?

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 Gilead 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."

Gilead Sciences has an intangible assets ratio of 64%. This ballooned up from 12% in recent quarters due to the $11.1 billion acquisition of Pharmasset. $10.7 billion of that was classified as intangible assets, called "in-process research and development."

It's also useful to look at 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."

Gilead's tangible book value is -$5.5 billion. The Pharmasset acquisition caused this number to go negative.

Foolish bottom line
If you own Gilead, the worry is whether -- at a 59% premium over the all-time high --it overpaid for Pharmasset.

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.

Keep up with Gilead Sciences, including news and analysis as it's published, by adding the company to your free, personalized watchlist.

The article Keeping an Eye on Gilead's Intangibles originally appeared on Fool.com.

Rex Moore owns none of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Gilead Sciences. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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