Friday, August 31, 2012

Valuation Techniques: Liquidation value

This is part of a series on valuation techniques.

When we talk about the value of a company, there are two fundamental components associated with it: assets and income. Very simplistically, we can view a company as a black box holding assets that grow over time in a stochastic manner.

I will define the liquidation value of a company as the net worth of a company's tangible assets in event of a bankruptcy.

How it useful?

Unfortunately, liquidation value isn't an accurate measurement of the intrinsic value of a company. Then how is it at all useful to an investor?

Neither accuracy nor precision are necessary conditions to make a profit in investing. The only necessary condition to successful investing is arbitrage. As long as we can buy a security for less than what it's worth, a profit can be made. Even if we don't know precisely what a security is worth, we need only to establish sufficiently tight lower bounds on the price to determine if it is a worthwhile investment.

That is exactly what the liquidation value is meant to provide. While it is difficult to predict the future earnings of a company, we still have a lower bound given by what the company currently holds. These figures are reported regularly on the balance sheet in financial statements.

Looking at the balance sheet

Most financial services (Google Finance, Yahoo Finance, Bloomberg, etc) will provide a summary of a company's recent balance sheets. Knowing how to properly read a balance sheet is critical to evaluating the current assets of a company.

Let's consider a snippet of Wal-Mart's Q2 of fiscal year 2013 balance sheets:

July 31, 2012 (Amount in Millions of USD) 7,935.00 5,365.00 40,558.00 159,919 20,081 195,661.00 125,383.00 70,278.00 3,383.54
• Cash and cash equivalents - amount of cash in the bank or stored in no risk, liquid securities like Treasury bills
• Total Receivables - unpaid debt owed to the company by customers due within a year
• Total Inventory - value of raw materials, goods in progress, and unsold finished goods
• Property and equipment - value of land, buildings, equipment, etc
• Goodwill - intangible amount of money put onto the balance sheet after an acquisition
• Total Assets - sum of all assets (in this example, it doesn't add up perfectly since I left out some more detailed lines)
• Total Liabilities - sum of all debt, both short-term and long-term
• Total Equity - total assets minus total liabilities
• Total Common Shares Outstanding - number of shares traded on the market

This should provide a general gist of things, though I left out a significant number of more detailed (and less significant) lines.

Estimating the Liquidation Value

So now that we have the company's balance sheet, it appears at first glance that the number we want is the total equity. After all, the total equity is the total assets minus total liabilities, a reasonable estimate for what a company would liquidate for.

Unfortunately the story isn't so simple. For example, in the event of a bankruptcy, there is no chance that the company will be able to liquidate the items in its inventory at its full value (e.g. out of business sales). In addition, not every item will be sold.

And so we must discount the assets in an appropriate fashion so as to come up with an accurate lower bound. Every company has assets in different proportions and types and so there's no catch-all discount factor. However, we can use some general guidelines (and tweak them on a per-company basis) for each individual asset type to provide a more accurate estimate.

Benjamin Graham proposed the following formula:
$NNWC = C + 0.75AR + 0.5I - L$ where $$C$$ is the total cash, $$AR$$ is the total accounts receivable, $$I$$ is the total inventory, and $$L$$ is the total liabilities. This formula is commonly known as net-net working capital (NNWC).

The original NNWC formula is rather too crude in my opinion and should include other assets like property and equipment.

I believe that each company requires its own tuned coefficients depending on the type of business. So in the general case, we have: \begin{align*} LV &> D_1 B_1 + D_2 B_2 + \dots + D_n B_n \\ &= \mathbf{D} \cdot \mathbf{B} \end{align*} where $$LV$$ is the liquidation value, $$D$$ is the discount vector, and $$B$$ is the vector of balance sheet items. Typically, we can impose some additional constraints on $$\mathbf{D}$$ such as: $D_i < 1 \\ D_{liabilities} < -1 \\ D_{cash} = 1$ Once a lower bound on the company value is established, simply divide it by the total number of shares outstanding to get a lower bound on the share price.

Determining Discount Coefficients

As I mentioned before, I don't believe there is a general method of determining these coefficients. It is mostly an art that involves a whole lot of research about the company and a strong intuition about the market. Not all available information is divulged in a company's financial statements.

If you scour the internet, you can find more specific information about particular allocation of assets. From this, you can make more educated estimates.

But one thing is certainly true, it is always better to err on the side of pessimism and caution. Remember, you are trying to establish a lower bound. Being overly optimistic or rushed can lead to bad investments.

Shortcomings

The primary issue with this technique is that it only provides a very loose lower bound. As such, it rules out the vast majority of stocks, leaving you with only a few potential winners. In more technical terms, you sacrifice a lot of statistical power in order to minimize the rate of Type I errors. By ignoring revenue, you are glossing over a large part of a company's value in hopes that it does not matter.

Another issue is that after filtering out companies based on this criterion, you must be very skeptical of the results. You should go ahead and verify that these companies are indeed worth investing in. Extraordinary circumstances can occur such as incorrect balance sheet reporting, money laundering, etc.

Getting Started

There are thousands of stocks out there so it's impossible to go through them one by one to apply this technique. The first step is to weed out stocks that cannot possibly satisfy this criterion. For this valuation technique, you can ignore all stocks with a P/B ratio greater than one. Most stock screeners will allow you to do this, including Google Finance.