Cheap? Or cheap for a reason?
Phil Oakley Oct 01, 2012
Recessions can do a lot of damage to company profits and share prices. You only need to look at what happened to the prices of banks, property companies and housebuilders during 2008 and 2009 to see that. Much of the time such a collapse in share prices is justified – but the stock market is also more than capable of overreacting.
So there can sometimes be very good money to be made in buying distressed companies. But how do you value them? And how do you tell the difference between shares that are good value, and ones that deserve to be cheap?
Looking at asset values
Cheap shares are often ones that are struggling to make a decent profit. So when you are digging about in ‘distressed’ stocks, it’s sometimes better to look at asset values to get a feel for a company’s ‘true’ value. You can find a company’s asset value on its balance sheet (found in the annual report).
Investors will often focus on the net asset value (NAV) or book value. It is calculated by adding up all a company’s assets – such as buildings and stocks of goods – and taking away all its liabilities – such as borrowings and money owed to suppliers. The NAV is always equal to shareholders’ equity in the business.
A company’s assets are financed by liabilities such as borrowings and money from shareholders (equity). This is why balance sheets balance. There is a school of thought that if you can buy a company at a big discount to its NAV then you might have bagged a bargain. But is this true?
NAVs are not all they seem to be
NAVs should be treated with caution. The NAV on a firm’s balance sheet and the true economic worth of its business can be very different. NAV is largely made up of accounting entries, based on costs. But stocks of finished goods or raw materials may be worth far less than their balance-sheet value. Debts may not be paid. A company may also have large intangible assets, such as goodwill (because it previously bought a company for more than its NAV).
This goodwill may be worth something or nothing at all. So if you are looking for cheap shares based on book values, it’s a good idea to remove goodwill from the NAV. On the upside, land and buildings may be worth a lot more than they are priced at in the balance sheet.
Top-viewed MoneyWeek video tutorials
The bottom line is that you cannot take it for granted that the NAV is what you would get if you shut the company down and sold everything. For example, it would probably cost a lot of money to make large workforces redundant, alongside liquidation costs. All these would reduce the amount payable to shareholders. That said, you can make money buying stocks below NAV.
Legendary investor Benjamin Graham made huge profits by buying stocks for the value of cash, stock and debtors, less all liabilities. These are known as net working capital stocks, or ‘net nets’. There are very few of these on today’s stock market. But there are still plenty of stocks trading below NAV.
Sanity checks for net asset values
So let’s say you find a company trading below its NAV. How do you work out if the balance sheet value is believable? Unless you have an intimate knowledge of the company’s balance sheet, it’s virtually impossible to work out on a line-by-line basis. But that doesn’t really matter – by looking at asset values in isolation you could be missing an important point.
While some assets have a liquidation value, their real economic value is down to the profits and cash flows they produce. Unless those assets can produce a satisfactory return for the investors who finance them, they are not worth their balance-sheet value.
To see if this is the case, you could look at the company’s return on equity (ROE – ‘profits after tax’ divided by ‘net assets’). If the ROE is high enough – say, above 10% – and can be sustained, then you might think the NAV is well supported.
But ROEs can be inflated by having lots of debt. This is because all the debt reduces the NAV, but profits are only reduced by the interest on it. So you must look at the returns on all the company’s assets and all the equity and debt that financed them. To do this, you need to calculate a company’s return on capital employed (ROCE) or return on assets (ROA).
Banks and builders are not cheap
The shares of British banks are very distressed and trade on big discounts to their NAVs. But a sanity check on their asset values tells you they deserve to be. Even before the onset of the financial crisis, banks have never been great businesses.
Their returns on assets (‘profit after tax’ divided by ‘assets’) are miniscule. The only way they could make acceptable returns for shareholders was to borrow lots of money and take on lots of risk.
Last year, Barclays’ ROA was just 0.3%. By gearing itself up a staggering 24 times (assets/equity), it made a 6.1% return on shareholders’ equity. Now you know why Barclays is worth less than its NAV – its returns are poor and its risks are too high.
The same could be said for housebuilder Barratt Developments. Its shares trade below NAV because its ROCE (‘operating profit’ divided by ‘capital employed’) is less than 5%. With house prices still expensive, there’s good reason to question the value of its assets.