The buying methodology I share in my book, Choose Stocks Wisely, is premised on the fact that a share of common stock is a share of company equity. Equity means ownership. On that basis, I seek out a low price for a share of company equity where I derive the value of the equity from the balance sheet’s revelation of the amount and composition of that equity.

If you have read my book and tried out the strategy for evaluating stocks, you know that my practice is to exclude the balance sheet amounts for goodwill and intangibles from the company’s equity (or book value). That is, I assign to those particular asset accounts a value of zero which is very conservative. I say “conservative” because they may indeed have intrinsic worth when it comes to the company’s ability to produce future earnings. For example, GEICO, a wholly owned subsidiary of Berkshire Hathaway Inc, has crafted some incredibly effective advertising campaigns for its insurance programs. Surely, the money spent on these campaigns has built company goodwill that drives future sales performance.

Nonetheless, the goodwill asset and the intangible asset are too hard to evaluate in terms of their cash worth, so my methodology assigns a value of zero “at the time I’m buying” under my balance sheet approach. Again, I want to be conservative when arriving at a price I’m willing to pay for a share of stock (equity).

“After” I buy, I’ve occasionally experienced situations where a company in my portfolio acquires another company. Often, additional goodwill and intangibles are recorded by the acquiring company to its balance sheet to represent the nature of assets attained in the acquisition. Thus, after an acquisition, the balance sheet of my company may change significantly such that it has more of its equity composition in the form of goodwill and intangibles than before the acquisition.  This means the company’s adjusted floor price would likely be reduced, and possibly significantly. In effect, tangible assets like cash, etc., got exchanged for assets of non-tangible composition in the process of acquiring the other company’s assets.

So, do I suddenly consider selling my position because the adjusted floor price may now be well below the company’s stock price due to the acquisition’s accounting impact to my company’s balance sheet? Well, I’m going to analyze the balance sheet again (post-acquisition), first making sure it still reflects my quality requirements (ample liquidity and solvency). If quality has been so adversely impacted by the acquisition as to cause my standards to be failed, I’ll look to exit my position because quality is a must for me.

If quality remains intact, I’ll review the acquisition. If management says the deal is surely accretive (will add to the company’s future earnings per share, or eps), I’m more inclined to stay with my position. Yes, there’s less tangible equity supporting my position but the company is saying that it has acquired something of greater value than what was given up to acquire it.

Finally, while I will not likely sell my position because of an acquisition’s impact to the balance sheet (change to the equity composition to a more intangible nature), it would not be a company I would buy today if I didn’t already own it because, when I buy initially, I want to get the stock cheap and my definition for cheapness is the adjusted floor price.