Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice, based on our stock market research. Each Investor Toolkit update gives you a fundamental piece of investment strategy, and shows you how you can put it into practice right away.

Tip of the week: “Goodwill should play an important role in your stock market research”

When we’re looking for stocks to recommend in our newsletters and investment services, we put a lot of importance on the amount of goodwill that a company carries as an asset on its balance sheet.

Goodwill is an accounting entry that reflects the price that the company paid for its acquisitions, minus the value of the tangible assets, like land and equipment, that it received as part of the acquisition. The term means “value as a going concern.”

However, goodwill acquired in an unwise acquisition can lose value overnight. When that happens, the company has to write it off against earnings. At worst, the company might have to write off most, if not all, of its goodwill.

If that writeoff wipes out most of the company’s shareholders’ equity, and/or most of a year’s earnings, it can devastate the share price. That’s a situation you should avoid at all costs.

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Stock market research: It pays to go beyond the numbers when assessing a company’s goodwill

Even though companies with high goodwill carry a greater risk of writedowns, your investing strategy shouldn’t automatically dismiss these firms. Canada Bread (symbol CBY on Toronto), one of the stocks we analyze in our Successful Investor newsletter, provides an example of this kind of situation.

Canada Bread has $375.9 million of goodwill on its balance sheet. That’s a high 47.8% of shareholders’ equity of $785.8 million. But it’s a more reasonable 31.3% of the company’s $1.2-billion market cap (the company’s share price multiplied by the number of shares outstanding).

More important, the goodwill was largely added to Canada Bread’s balance sheet from a series of acquisitions the company made in 2002. Most of the companies that Canada Bread bought were small. But they did include its December 2002 purchase of parent company Maple Leaf Foods’ U.S. and U.K. bakeries, including Grace Baking Company, for $262 million.

The companies that Canada Bread bought in 2002 have proven profitable, and are a stable part of its operations, so the chance of a writedown at this point, eight years later, is small.

Next Wednesday, March 9, 2011, Investor Toolkit will give you our investment advice on how to interpret insider trading.

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