Time tested stock investing approach

Time-tested stock investing approach

Ben Graham in 1940 recommended having ‘margin of safety’ while investing in stocks. This approach was practised by many investors including Warren Buffet and it surely worked.

The company’s worth is roughly equal to asset’s worth less any liabilities.

But what about growth and profitability? This class of investors often don’t like paying for future growth but are comfortable paying for asset value and current earnings (Earning Power Value). Let’s just focus on asset value approach for now.

Value based on Assets 

Any company’s value can simply be its asset value. Well, this is the first level of assessment that can represent the baseline of company’s value.  

Any company has two kinds of assets i.e. current and fixed. Most of the current assets represent its fair worth in the balance sheet. However, fixed assets have to be assessed since the likelihood of fixed assets value in the balance sheet is low. For example, land bought fifteen years back will be worth lot more than what is mentioned in the current balance sheet. 

There are two ways to look at a company’s asset value: liquidation value or reproduction value. 

Liquidation value

This is the value assuming the company is closing down. The analyst maybe trying to assess whether to buy distressed debt or equity. 

Here is a sample balance sheet to assess liquidation value: 

Sample balance sheet

Assets

2018

2017

Current assets

 

 

Cash

150

145

Marketable securities

25

70

Accounts receivable

1667

1525

Inventories

2329

2250

Total current assets

4170

3990

 

 

 

Plant, property and equipment

7500

7750

Goodwill

2250

2400

Deferred taxes

150

155

Total assets

14070

14295

 

 

 

Liabilities and equity

 

 

Current liabilities

 

 

Notes payable

2200

0

Accounts payable

1417

850

Accrued expenses

1250

725

Current portion of long term debt

9500

9250

Total current liabilities

5387

2075

Long term debt

9500

9250

Deferred taxes

125

150

Preferred stock

350

350

Paid-in capital

850

850

Retained earnings

(2141)

1620

Total liabilities and equity

14070

14295

Let’s deep dive


Cash and marketable securities are taken as mentioned in the balance sheet.

Account receivable will probably not be recovered in full, but since it is trading debt, we can estimate that we can realize 85% of the stated amount.

Inventory valuation depends upon the type of inventories, more specialized inventory will fetch lower amount.

The same logic applies to plant, property and equipment as well. I have assumed 50% inventory realization and 45% plant, property and equipment realization.

Goodwill will not fetch anything and deferred taxes will get adjusted to the liabilities.

Assets

2018

Percentage realized

Value

Current assets

 

 

 

Cash

150

100

150

Marketable securities

25

100

25

Accounts receivable

1667

85

1417

Inventories

2329

50

1164

Total current assets

4170

 

2756

Plant, property and equipment

7500

45

3375

Goodwill

2250

0

0

Deferred taxes

150

0

0

Total assets

14070

 

6131


Account payable and accrued expenses amount to only 2,667. After paying for these liabilities 12,220 will still be left as liabilities.

Given the condition of the company, if a steep discount is available on debt, investing in this is not a bad option. Stock investing in this company may not make sense. 

Reproduction value

If a company operates in a viable industry then the economic value of the assets is their reproduction cost i.e. what a competitor has to spend in order to get into this business.

Current assets

Cash and marketable securities do not require any adjustment. A new company starting out may not be as effective in getting the payments from the customer. Therefore, adjusting for allowances in accounts receivable is a better idea.

Valuing inventory can be a daunting exercise. Based on the industry, the analysis needs to be performed especially inventory / COGS to understand if there is any pilling up of inventory.

Additionally, if the firm uses LIFO method of inventory reporting, LIFO reserve should be added back because the new firm may not be able to source inventory at last years price.

Fixed assets

Plant, property and equipment may be shown as one item but they are actually three. Land usually appreciates; assessing the market value of the land is a better idea.

Plant and building use depreciation allowance that may not represent the true picture. The competitor has to pay lot more than what is usually shown on the balance sheet.

The adjustment made in the equipment value may be up or down, depending on the industry but it is not so massive.

Value of goodwill needs to be understood rather than relying on the balance sheet number. Goodwill is an accounting entry but a company may enjoy premium due to its reputation.

Goodwill may be linked to R&D and marketing expense of the company. You should be able to answer “How many years will the product take to establish its market?” if the new company were to enter the industry. 

Adjustment required arriving at reproduction costs

Assets

Adjustment required arriving at reproduction costs

Current assets

 

Cash

None

Marketable securities

None

Accounts receivable

Add bad debt allowance; adjust for collections

Inventories

Add last in, first out reserve, if any; adjust for turnover; watch out for changing ratio of inventory/COGS

Prepaid expenses

None

Deferred taxes

Discount at present value

Plant, property and equipment

Original cost plus adjustment; land usually gets a premium and equipment/plant have to be discounted

Goodwill

Relate to product portfolio and R&D and marketing

Asset value needs to be compared with earning power value (EPV)

If you are up to dig into annual reports for the last ten years, EPV can help you find great opportunities.

Well, enough for now, EPV for some other day!

Comment (2)

  • Jayna Gandhi| April 25, 2018

    A have not understood liability side of the balance sheet

    • Ankur Kapur, CFA| April 25, 2018

      I think you are referring to liquidation value related liability adjustment. Given the example, equity investment does not make sense from pure liquidation point of view. Therefore, if the secondary market offers a discount on debt, you can evaluate debt investing in this company. This may be the case in bankruptcy proceedings.

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