As mentioned in my basics course on value investing, the first step I take in valuing a company is discovering its net asset value. That is, the value per share of the company’s assets after accounting for (subtracting) all liabilities. If the company is healthy, and operates in a viable industry, the assets should be marked to their replacement value. These assets need to be replenished as they are used and any competitor wanting to enter the industry would need to pay fair market value in order to acquire similar assets. This replacement value is the normal case and would then be followed by an analysis of earnings power value, as discussed on this site previously.
What if the company is in trouble? Perhaps the company is in imminent threat of default and is not expected to continue normal operations into the future. Earnings power analysis is then useless as we can expect the company to liquidate its assets in order to pay debtors, with holders of common equity receiving the leftovers. In this case the assets of the company should be valued at liquidation value. We assume all assets are to be sold off to the highest bidder. Liabilities are then subtracted from the value of these assets to find what would remain for the holders of common equity.
As value investors, we don’t only consider companies that have long-term holding potential. Value investing is about buying an asset for less than it is worth. In some instances this may involve purchasing a company facing bankruptcy if the investor has conviction that the assets will be worth more to the common equity holder after liquidation than they can currently be purchased for, always including an appropriate margin of safety.
Valuing assets at liquidation requires a great deal of expertise and may require the services of an expert valuator. Keeping some things in mind, however, should assist you in arriving at a reasonable estimate when needed.
- Asset liquidity. The more liquid the assets are, the more likely they are to be sold at book value. For instance, cash is always valued at book value even in the case of liquidation. Marketable securities are another example of a highly liquid asset.
- Failing business vs failed industry. If the business being liquidated operates within a thriving industry then you can expect that there may be competitors willing to purchase the assets. In the case of a non-viable industry however, assets on the balance sheet are more likely to be sold at scrap prices.
- Asset specialization/customization. The pool of potential buyers shrinks the more specialized or customized the asset being sold. A warehouse that is just a stock space for storing items will have many potential buyers and will likely be sold at close to fair value (given a decent real estate market and enough time to sell). On the other hand, a warehouse that has been custom built and designed to house specific types of goods needing special care will likely be sold at far below replacement or fair value in the case of liquidation. It is important to keep industry conditions in mind though as even in the case of very specialized assets on the balance sheet, these assets could have a fair chance at being purchased closer to their replacement value if the industry is viable. In the case of a thriving industry, competitors will likely be bidding to purchase the asset in order to acquire the extra capacity on the market.
While valuing balance sheet assets at liquidation value can be a difficult task, keeping the above concepts in mind should assist you in arriving at a realistic estimate of their value. Best of luck, and as always I will do my best to respond promptly to questions and/or comments posted below.
More on this topic
(What's this?)
7 Investor Traits to Achieve Success
(Dividends Value, 8/13/09)
Value Investing Podcast - The Value Guys
(Australian Stock Market Blog, 8/12/09)
Value Investing Congress: Discount for Market Folly Readers!
(market folly, 9/9/09)
{ 11 comments… read them below or add one }
Jonathan, I read this blog with mild interest, but if you had included a lot of examples from real companies and real annual reports; it would have been really interesting. For example I lost my whole investment two years ago becuase I did not read the balances sheet well enough of POPE & TALBOT INC (PTBTQ), a 150 year old paper mill company who had to go bancrupt the year I owned it. It turned out the machines were not as valuable as on the balance sheet when they were sold on the open market…
Hi Balans,
You are right, nothing can beat actual experiences and examples. Thank you for sharing yours. As you may be able to tell, haven't had much time the past few weeks to even look at specific companies… in the middle of a lot on the personal front right now. I am a big believer however in sharing actual examples and I do plan on getting back to that soon.
I hope you keep reading… even with mild interest!
All the best,
Jonathan
I recently stumbled across your blog and wanted to offer you some encouragement to continue your efforts. I also agree with the individual that responded that real life examples are best and I think you will find that they will also stimulate the most discussion.
I wanted to bring your attention to PARL a prestige fragrance manufacturer which presently generates approximately $150 million in annual sales. The company has operated around breakeven (below last year and above the year before) over the last two years under a new CEO. The company meets the classic Ben Graham value investing criteria of having its net liquid assets (current assets less all liabilities) exceed its market cap be over 2x. Better yet, with recent license agreements (Queen Latifah, Marc Ecko, Rhianna, Kanye West, Jay-Z and a potential well established female artist as referenced in an April PR), the company should post sales growth over the course of the next several years as a result of launching fragrances under these licenses. The products provide gross margins in excess of 50%. New licenses are restricted distribution within the department store sector in their first year and do require significant advertising in the year of launch. This combines to not provide profit growth until their second year when the products are made available to mass market retailers and internationally while at the same time requiring reduced advertising. It's my belief that PARL will begin to post profits again this fiscal year and continue to grow sales and profits over the next several years and has earnings potential of up to $1 per share once $300 million in sales volume is achieved. I believe that the current stable of licenses can get PARL to that sales volume. While an investor waits for this targets to be achieved, the margin of safety represents twice the current share price of the stock. I think this is a winning combination.
Anon, thank you for the insight. If I can make time for it I will definitely look into this company further. Please keep reading and contributing!
Best,
Jonathan
Jonathan- First, I love your rational thinking when looking at value investing. It’s a great tool in the investment process, but I have always felt it is simply a tool or compass and nothing more, it points you in the right direction when looking at a company/industry (Implying the entire top-down approach to security valuation is a compass). Relying purely on fundamental analysis and ignoring market timing and or technicals of a company/industry is reckless and irrational… Labelling oneself a complete “value investor” is, in my mind, similar to being completely right or left wing in regards to the political arena…certain situations and opportunities arise and call for all types of security analysis so trust me…MARKET TIMING IS EVERYTHING (even an undervalued stock according to fundamental analysis may be overvalued if market timing is missunderstood or not captured in the fund. analysis)…I understand you did not imply that it is meaningless but please elaborate on its true importance.
By the way I posted this on the wrong article…
I definitely hear you. The thing is sometimes the best value can be found when everything about the market is telling us to stay away, hence the buying opportunity. It is very hard to give hard rules for this as obviously you want to be sure that in the long-term the value will be realized. If I value a company based on last 12 months’ earnings and I believe this to be sustainable in the future then that is all the market information I really need. Granted, technicals can benefit in finding intra-day entry points. Also, levels of support/resistance may be a benefit to understand in placing orders as well. But beyond that it really is difficult to “time” the market and that is why so many people get burned trying to do so. You need to understand the company and its long-term prospects as well as you possibly can, that is how you get the leg up on the market. When you find value, I say buy… if you wait it out to time the market as accurate as possible then you may miss the opportunity – the market always surprises.
Would love to hear your thoughts on this.
The Market “is an irrational monster”… it can prove all investors wrong regardless of their viewpoints concerning analysis technique preference. I could provide endless examples of investments went bad, either because of attempting to time the market, or trying to determine the investments intrinsic value…but eithere way, if you mis-time your decision or analysis the results may not be what you’d expect. Comparing PE’s or looking at a companies NAV requires A LOT of market timing, or at least timing with respect to when you perform your analysis and value your inputs. It is my opinion that fundamental analysis is only as accurate as the markets are efficient…fundamental analysis is always relative to other variable such as peer companies, benchmarks, industry averages, and comparable companies values…One must understand where the market is at any point in time, or the results found in the fundamental analysis have limited use. A PE of 15 compared to the industry average of 20 looks cheap all things being equal, but if the market is wayyyy overpriced and analysts estimates are way to high, the stock with the 15 PE is still overpriced even though the analysis shows it being underpriced relative to its competitors/the market. I understand I strayed from pure market timing there…but I still feel my point that combining different analysis techniques and having an open mind is important.
Also, I am preparing a short essay on the importance of a well rounded investment analysis technique that I should be able to finish this weekend, I will send you the link when it is done.
Shawn, thank you for contributing your views to the site. I think it would be great to get other readers involved in this discussion and I am working on making a way for that to happen… coming soon! In the meantime though I look forward to the essay. If you’d like I can consider it for a possible guest submission on the site… could be of great value to the readers here. Be in touch.
Very awesome writing. Really.
If only I had a dime for each time I came to http://www.jonathangoldberg.com... Superb writing!