A simple case study of liquidation value and how it is arrived at, as presented at the Vancouver Value Investors Club
“We do liquidation analysis & liquidation analysis only.” - Peter Cundill
One of the most simple and straightforward, as well as most useful estimations of intrinsic value is the liquidation value.
The equation to estimate approximate liquidation value is:
(Cash & Cash Equivalents + Accounts Receivable + Inventory – Total Liabilities)
Benjamin Graham created this equation in the late 1920’s to help him determine if a company was valued in the marketplace below its approximate liquidation value. Graham believed investors could benefit greatly by buying a basket of companies whose share prices valued them below their Net Working Capital.
Indeed, by primarily applying this strategy (along with some others) Benjamin Graham’s Graham-Newman Corp. achieved an average compound rate of return of approx. 21% annually for 20 years from 1936-1956. That’s some back test!
In order for this equation to turn out accurate and reflect reality one must discount the accounts receivable (to factor in for doubtful accounts) as well as the inventory which seldom receives anything close to stated book value in a liquidation scenario. Therefore the adjusted equation should be such:
(Cash & Cash Equivalents + Accounts Receivable (75% of book) + Inventory (50% of book) – Total Liabilities
Inevitably, sometimes even buying a dollar for fifty cents is not enough. Therefore a word of caution: since companies valued at such depressed levels don’t usually have the greatest businesses in the world, it is highly advisable to delve deeper into their financial statements and learn some of the following points:
- Makeup of Current Assets, a large cash position is always preferable to a large amount of Accounts Receivable and Inventory on the books.
- The less debt on the liability side the better, best to make sure that whatever debt does exist is not short-term debt coming due and if it is make sure that the payment of such debt from cash & cash equivalents will not decimate your margin of safety. (when investing surprises are usually of the unpleasant kind)
- A profitable company, even marginally so is highly preferable to one that is heavily in the red and burning through cash as this can quickly dissipate one’s margin of safety.
- Look for a catalyst which if executed properly can realize the asset value of the company. This can take the form of a stated intention from management to liquidate the business and distribute proceeds to shareholders to a sale of the business.
Since things have changed somewhat since Graham’s day, Net-Nets as companies selling below approx. liquidation value are often called do not abound a plenty as they did back then. There are several causes for this, markets have become more efficient, there are a greater number of investors (both amateur and professional searching for such opportunities and of course for better or worse (i would say worse) there is an endless stream of real time information available at one’s fingertips now.
However, please do not take the above to imply that such opportunities cannot be found. If one’s looks hard enough (usually around the market’s corners and crevices) one can find a few and or more Net-Nets. Below are two examples of such enterprises as of Feb. 15, 2012:
Urbana Corporation (TSX: URB) is a Canadian based investment company. The company invests primarily in stock exchange index funds and owns a portfolio with a net asset value of approx. $2.02.
The shares of URB currently trade in the market at $1.03 (as of Feb. 15) which is a 99% discount to NAV.
Additionally, there is a catalyst already in place as Urbana’s president Tom Caldwell whose private firm Caldwell Asset Management Inc. owns approx. 45% of the company’s voting shares (URB.A) is committed to purchasing non-voting shares (URB) back. Indeed the company has reduced the number of shares outstanding since 2010.
Hardcore Value, Saj Karsan & Whopper Investments also have very informative write-ups on the company and indeed Urbana initially came to my attention through their writings therefore they deserve all the credit for this finding.
Eastern Energy Infrastructure Invest AG
Eastern Energy Infrastructure Invest AG (SWX: EEII) is an investment company listed on the Swiss based SIX exchange. The company owns a strategic portfolio of select companies which are active in the energy and infrastructure sectors.
The company currently holds interests in ten Ukranian utility companies, two of the largest oil companies in the world, Ukrnafta (largest oil producer in Ukraine) and Gazprom which is the biggest oil company in the world. EEII also owns a stake in ENRC, a Kazakhstan based diversified natural resources group.
The Net Asset Value of this investment portfolio is 23.28 CHF, compared to the current share price of 14.50 CHF.
Some additional ratios will shed further light on the company and how attractive it really is at its current valuation:
- Earnings Per Share: 14.04 CHF
- Book Value Per Share: 27.79 CHF
- Revenue Per Share: 14.64 CHF
- Return on Investment (ROI) 66.31%
You read right, the above figures are no typo! This implies a P/E ratio of approx. 0.01 as the company is valued in the market at a price barely above its per share earnings.
While the two companies described above are not traditional Net-Nets in the sense that they are not operating businesses themselves (rather they own operating businesses) they meet the timeless quantitative test of clearly being valued below their current assets alone.
These two examples simply illustrate that no matter where in the world one looks, if you turn over enough rocks you will find some hidden treasures. Happy exploring!