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Shades of Value
An intro to fundamental equity metrics and common definitions in value investing. How well is the accounting grounded in reality? And when are we valuing and not just pricing? (Background)
This Background introduces new readers and investors with an overview and discussion of equity value metrics and definitions commonly used in value investing.
Johan Eklund, CFA
An Equity Value Toolbox
Equity = Assets - Liabilities
But what asset and liability values are we going to use? The answer as always: it depends on what we are going to use it for.
Below is a map of how different equity value metrics apply in different value situations. (If the chart becomes too tiny on a smartphone: Try flipping the screen to horizontal. Or revisit the article on a desktop or reading pad.)
Here is a summary of the equity metrics, listed from the most conservative:
Price/”Net-Net” Working Capital (P/NNWC)
“At their low price, these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.”
— Benjamin Graham and David L. Dodd on “net-net” stocks in Security Analysis (6th Edition, The McGraw-Hill Companies, 2009, p.570)
The “net-net” metric, as popularized by Benjamin Graham and David L. Dodd is a conservative liquidation value estimate. It is a quick way to ensure that we buy stocks for what is likely only a part of their value if they go into liquidation soon. And for much less than business value, if their businesses continue (as going concerns).
The net-net formula is straight-forward, but it comes with assumptions and conditions:
= Market Capitalization / [[Cash + Short-Term Investments + Discount% x [Accounts Receivable + Inventory]] - [Total Liabilities*]]
= Share Price / [NNWC / # Shares Outstanding]
Assumptions: Only a few current assets are accepted as liquidity. Further, we are advised to set conservative discounts on accounts receivables and inventory values. Graham and Dodd used 0.75x receivables and 0.5x inventory for general situations.
Conditions: Graham and Dodd (Security Analysis, 6th Edition, p.570), required two more characteristics of the companies:
Cannot be at “apparent” risk of consuming (“dissipating”) these assets.
Must have “formerly shown a large earning power on the market price”. In other words, must have a history of profitability.
Pro: A diversified portfolio of net-nets is a good, aggressive mean reversion strategy offering some fundamental** downside protection in the liquidation value.
(** Not to mix up with price risk, or volatility, measures. See e.g. Alpha Architect for a critical review of the evidence.)
Con: The main issue is that there are few investable net-net:s in today’s more efficient markets. Mechanical screening may end up with many “melting ice cubes”, with cash-burn or contingencies that fail the quality conditions above. To find a set of decent-quality ones, we have to accept other risks. For example, investing in smaller market capitalization and/or in less efficient geographies. That makes net-nets a difficult main strategy for larger or restricted portfolios.
Price/Net Current Asset Value (P/NCAV)
= Market Capitalization / [Current Assets - Total Liabilities*]
= Share Price / [NCAV / # Shares Outstanding]
A simpler but much less conservative liquidation proxy. In short: Your Analyst would advise against using NCAV as a standalone metric. Graham and Dodd described screening for (2/3) x NCAV stocks, but that is an arbitrary workaround.
Pro: Very fast and easy to calculate and use in screening.
Con: Not all current assets are likely worth 100% of their accounting book values in a liquidation. NCAV will include intangible current asset accounting items, such as prepaid expenses. These are most likely not worth their book values if operations are shut down suddenly. So not a good liquidation estimate. Nor is NCAV a good “asset play” metric, as it ignores marketable long-term assets, regardless of quality.
Price/Tangible Book (P/TBV)
= Market Capitalization / [[Total Assets - Intangible Assets] - Total Liabilities*]
= Share Price / [TBV / # Shares Outstanding]
Among widely available, unadjusted book value measures PiggyBack prefers P/TBV for quick screening of potential asset play-type stocks to analyze further.
Pro: Very fast and easy to calculate. Supported in many screeners. By ignoring intangible assets, TBV offers a partial solution to reality-distorting goodwill***.
Con: Susceptible to distortion by choice of accounting policies and accounting assumptions (other than goodwill).
Price/Book (P/B or P/BV)
= Market Capitalization / [Total Assets - Total Liabilities*]
= Share Price / [BV / # Shares Outstanding]
Pro: Very fast and easy to calculate and use in screening. Widely available in not only equity databases but also longer-term historical data series. Easy to relate to accounting earnings multiples (P/E) and popular valuation models.
Con: Very susceptible to distortion by accounting rules, including goodwill***.
Accounting sets rules-based records, not maps of reason
Accounting provides rules-based and backward-looking records. As equity investors, we make great use of this information as model input. Often accounting analysis may also provide early hints of significant risks or opportunities.
But accountants do not help us in assessing an investment's economic returns. That is a return above the investment's cost of capital. Neither do accounting book values offer precise estimates of intrinsic value.
To move beyond screening, we must collect more information and make forward-looking assessments. In other words, draw useful maps of what is likely to happen next. In future analysis, PiggyBack will combine historical data checks with forward-looking assumptions. We do so to become more confident of the intrinsic value on balance sheets, but also from earnings power and franchise growth value beyond this.
The distinction of screening versus valuation is made much more clear by Aswath Damodaran, Professor of Finance in a recent Aswath Damodaran - Making Sense of the Market episode on the Invest Like The Best podcast:
“When is the last time you actually valued a company? And don’t tell me you buy companies at low P/E ratios and high dividends or whatever it is. That is not valuing the company, that’s just running screens. Maybe one in a hundred actually values companies… They say they don’t value companies because they don’t like to make assumptions. What? Investing is a set of assumptions. The fact that you are using past data does not mean you are not making assumptions, it just means you are not making assumptions explicitly.”
— Aswath Damodaran, Professor of Finance, in the recent episode Aswath Damodaran - Making Sense of the Market on the Invest Like The Best podcast
Read Musings on Markets: PiggyBack views Mr. Damodaran as a great teacher, thinker, and resource in the world of valuation and markets. Follow some of Damodaran’s great work on his (still underfollowed) Substack at:
Price / Reproduction Value
Reproduction values/costs attempt to explain the cost for competitors to hypothetically recreate a company's current assets in place.
Usually, this assessment is a matter of collecting reasonable market valuation price points. Like appraisals or recent market transactions for the assets in question. It may also be abstract, like imagining an invisible Research and Development (R&D) “asset” based on R&D expense. (Technically: capitalizing R&D on the balance sheet.)
From our equity investor perspective, reproduction values may involve liability adjustments as well. (As the value of liabilities affects our residual equity value.) For example, the reproduction values of debt-levered companies are extra sensitive to the market value of debt. If interest rates or the credit market (credit risk premiums) change significantly, we can adjust the value of debt.
Pro: In complex capital structures, reproduction values may highlight “hidden” values.
Con: Compared to accounting metrics, this process may require considerable effort in sourcing data. Despite this, reproduction values are not complete fundamental valuation frameworks. They lack forward-looking assumptions and important return on capital to cost of capital links. So for operating businesses, consider using some NAV valuation framework instead. (For complex structures Sum Of The Parts, SOTP, can combine reproduction values with forward-looking assumptions.)
Price/Net Asset Value (NAV)
NAV:s are the outputs of doing a complete valuation with some explicit assumptions.
The Net Asset Value (NAV) is the output of fundamental valuation models that:
Use forward-looking assumptions to forecast fundamentals such as cash flows, dividends, or investment returns.
Discount the forecast fundamentals' Net Present Value, NPV, using some appropriate cost of capital.
Add/deduct NPV:s of relevant balance sheet items not captured by the forecast NPV. Arrive at the NAV.
Pro: Combine a consistent valuation framework with reasonable assumptions that capture risk-reward. Then NAV is our intrinsic value estimate for the investment.
Con: Valuation work is a much more time- and resource-consuming process than pricing stocks based on relative criteria. Nor is it just applying some quantitative filter (like a P/TBV discount screen). So investors must focus their valuation efforts or their acquisition of research. Preferably to situations or themes that they (1) have reason to believe are mispriced, (2) already have committed to, or (3) wish to learn more about.
“It is better to be vaguely right than exactly wrong.” — Carveth Read
Caveat 1: Valuation does not necessarily mean extremely complex or large models. Nor does it mean including the most information or establishing the closest insider access. What such factors will produce is a highly detailed analysis. But beware that if it lacks common sense and probabilistic thinking, it may also be a very biased analysis.
Caveat 2: Without reasonable assumptions, a valuation model is just a mechanical framework. It can be corrupted to arrive at basically any NAV “needed”. If we notice serious conflicts of interest and a lack of research independence, we can still study such analysis. But we do so for business or sector insights. Not for using its valuations.
Venture investments are an interesting special category of high-flying investments. In stock markets, they tend to be found among micro and small caps and in technological industries. This technology- or business innovation-driven investments are usually early-stage and explosive growth. They have some low-probability shot at becoming competitive future industry leaders. At least that is the story they all must tell to raise their capital needs.
Ventures are more like innovative equity options than operating businesses. We do not use our value-investing tools here. Instead, we need venture financing analysis, with more focus on entrepreneurs and innovation. Few value investors specialize in this. But we will find ventures on the books of listed corporations and holding companies. So it is good to understand that they have their playbook and that they may, possibly, be worth more than the average extremely high multiple stocks.
“Fair” Market Folly
Market prices for liquid securities are set where demand meets supply for the day. This pricing has nothing to do with long-term fundamentals or valuation.
Pricing is the basis for the accounting concept of fair market value, as long as the parties are knowledgeable and not forced traders. Appraisal in for example real estate is asset-based market pricing. Neither reflects intrinsic value, in taking into account the cost of capital versus forward-looking assumptions.
Pricing without valuation also means that we allow any level of short-run overvaluation. Eventually, we can no longer value an investment based on common-sense fundamental assumptions. By then, most participants chase price momentum or throw around loose relative multiples. (The “my-laser-eyed-golden-skin-ape-picture-is-worth-at-least-twice-your-diamond-skin-ape-picture” type of reasoning.)
Other practitioners and promoters will still use valuation, like a discounted cash flow model. But study those “valuations” carefully, as they often rely on very aggressive implicit key assumptions.
Sometimes we are proven wrong. Some speculative investment themes materialize into strong fundamentals, that grow into their prices. But as we have discussed before, the highest valuation "glamour" part of the stock market tends to underperform over cycles. Markets get overconfident and overvalue shiny, popular objects of their day.
Multiples of hundreds of times earnings, or worse revenue, call for extreme success. This should not be accepted as likely based on just “this time is different” storytelling. Then we are just speculating to sell even higher to some Greater Fool, a very different game from valuing speculative investments.
Your Analyst sincerely hopes all readers enjoy and get inspiration and value investing ideas from PiggyBack. If so, consider sharing PiggyBack with friends and colleagues:
Only with the help of early readers will this publication reach a sustainable scale for free, independent insights. Many thanks to all PiggyBackers!
Johan Eklund, CFA
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* Technical Note: Exclude Other Equity
When we calculate common equity to the shareholders of a parent company we also exclude:
Preferred Equity and other equity-classified instruments that are senior to the common equity.
Minority Interest in the common equity.
*** Technical Note: Goodwill
One accounting concept that makes financial statements difficult to accept at face value today is goodwill.
Major frameworks like IFRS (International Financial Reporting Standards) and various national GAAP (Generally Accepted Accounting Principles) treat goodwill weirdly.
The core of the problem: major intangible values that are built up in businesses over time. For example brands and customer loyalty do not show up on the balance sheet. Instead, we notice them as some businesses stay more competitive in their industry.
While goodwill is linked to such intangibles in theory, it is not in practice. What the instead is limited to doing (and distorting) is mergers and acquisitions. Here is an example:
Say acquiring company A today buys another target company T for 100 units of currency in cash.
A then has its accountants revalue all the (identifiable) assets and liabilities on T’s balance sheet. Only to find that the equity value purchased was only 50 units of currency.
A’s remaining 50 units of acquisition payment that the accountants would not allow to be covered by acquired T assets is then balanced. This is done by just adding an imaginary “goodwill” asset of 50 units of value on acquirer A’s balance sheet.
For 100 units of cash paid acquirer A got T’s business with assets valued at 50 units plus 50 units of made-up goodwill. Goodwill is then rolled forward by A. This continues as long as A’s accountants regularly sign off on the assumption that the goodwill is intact (usually the case right until it is painfully evident that an acquisition strategy has destroyed value).
The result: Acquisition strategy companies will over time get balance sheets where the book value gets more dominated by goodwill. This distorts many financial ratios based on the balance sheet. In the years there are write-downs it also distorts accounting earnings and their input into financial ratios.
For fairer comparisons across companies and cleaner metrics over time, the easiest quick fix is to exclude goodwill as needed.
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