Notes derived from Chapter 4 of Value Investing: From Graham to Buffett and Beyond
The first step in analyzing a company’s assets (balance sheet) is to determine whether or not it is operating in an economically viable industry. If the industry is in decline, the assets should be valued on a liquidation basis, which assumes that most of the specialized capital goods will be sold for scrap having no other easily-converted use to other businesses. If the industry is stable or growing, assets should be valued based upon their reproduction cost.
The following rule-of-thumb discounts should be considered when valuing assets on a liquidation basis:
- Cash and marketable securities – 100% of value
- A/R – 85% of value
- Inventory – 50%- of value; the more commodity-like the inventory, the lower the discount
- PP&E – 45% of value; RE holdings may sell for more, specialized plant and equipment may sell for substantially less, an appraiser can be hired if this valuation is critical
- Goodwill – 0% of value; goodwill represents excess over cost paid for acquired businesses and customers, which are unluckily to hold significant value in a dying industry
Often the resulting discounted asset values may result in a deficit for equity holders, especially in light of large amounts of debt in the capital structure. It may even be possible that the debt holders’ claims are in deficit. In this case, the going price of the firm’s debt securities should be compared to this adjusted book value to determine if there is a distressed debt opportunity present.
Most businesses analyzed will be looked at as viable going-concerns.
The following are some rule-of-thumb adjustments that should be made for various current asset entries on the balance sheet:
- Cash and marketable securities – no adjustment, these are assumed to be highly liquid and worth their stated book values
- A/R – the assumption is that a smaller, start-up competitor might get stuck by its borrowers more often than an established firm, so you can add back in the bad debt allowance, or an average of similar firms
- Inventory – the average inventory in terms of number of days worth of COGS should be examined against the current inventory; an excess accumulation should be subtracted from the current inventory value on the assumption it is unsaleable; if using LIFO and prices are rising, add back the LIFO reserve because last year’s inventory must be rebuilt at this year’s prices
- Prepaid expenses – generally require no adjustment as they’re small and realistic
- Deferred taxes – should be adjusted using a present value calculation if long-term in nature
There are a number of adjustments that may be made to long-term assets, as well:
- Property/land – land may have been purchased long ago at much lower prices than it is worth today; similarly, land may have been acquired at the height of a recent bubble and its capital value may have since fallen
- Plant – due to depreciation schedules, real, productive assets with significant economic life or increasing market value may be written down to zero; similarly, the company may have been under-expensing due to inflation; whatever the case, a present competitor would have to pay today’s prices for equivalent plant and the adjusted balance sheet should reflect that
- Equipment – may be higher or lower and is industry specific
- Goodwill – arises due to acquisitions of businesses, customers, brands or other intangible items of value; if the acquisition was a poor one, goodwill may be significantly impaired, or worthless; other times, goodwill might be a paltry amount of the total economic value acquired
Recreating hidden assets – R&D, brand images, special licenses
There are many hidden assets that are not found on the balance sheets of most firms but which nonetheless would have to be recreated by their potential competitors and therefore are a real source of value to the company, such as technology created through R&D, brand images or market share-of-mind and/or special licenses or privileges from the government.
- R&D – the average length of a product cycle can be used as a multiple of average R&D expenses to recreate the “technology asset”
- SG&A – some multiple of average SG&A expenses, usually 1-3 years worth, are necessary to replicate the brand awareness, book of clients, etc. of an existing firm in the industry
- License or franchise – look for the price of recent sales of these assets in the market, usually in terms of a “per” number, such as “per subscriber”, “per population”, “per seat”, etc.
- Subsidiaries – again, look for private market or wholesale transactions, usually in terms of a multiple of cash flow such as EBITDA