Net Current Asset Value Method and Financial Analysis, Part 1.

Net Current Asset Value Method is strongly asset-based analysis method. Benjamin Graham developed and tested the net current asset value (NCAV) approach early 1930s. In this method, the calculation of the share value is based only on the information to be included in the balance sheet. Investors favored income statement is not essential. Neither cash-flow analysis nor relative valuation metrics such as price-to-earnings, price-to-book, price-to-sales, EV/EBIT or dividend yield ratios. The most significant balance sheet figures are current assets and total liabilities.

The common definition of Net Current Asset Value (NCAV) is:

NCAV = current assets – (total liabilities + preferred stock)

Sometimes it’s good to look behind the numbers and remember the importance of understanding what accounting numbers mean rather than what they are.

In this first part, we analyze the most crucial information taken from company’s balance sheet.

 

Current Assets

In general, current assets include all the assets that will be turned into cash within a year from the balance sheet date.

  1. Cash, cash equivalents and marketable securities

These are the most liquid assets in the balance sheet. The higher these assets are in relation to the NCAV of the company, the stronger the company’s valuation usually is. A company with large cash assets is seldom at risk of falling into bankruptcy quickly. That said, cash load could also be there because management has run out of investment opportunities and then you need to ask why the money is not being put to use.

Changes in cash and cash equivalents over a longer period can tell a lot about the company’s direction. Some companies of very low asset value are characterized by rapid depreciation of cash. The company’s constantly loss-making business quickly burns its cash which decreased NCAV over time. Investor should avoid such companies because as a result of decline in intrinsic value, the stock may no longer be undervalued and, in fact, may now be overvalued. These companies are easy to find, for example, among small pharmaceutical and biotechnology companies with large product development and research costs but still little real sales. Cash assets can also change rapidly as a result of acquisitions or business sales. The investor must always find out the reason for a major change in cash assets.

In a special case, you can find a company whose cash per share is greater than the share price. Then it may be a really cheap company that still gives a good margin of safety against the share value drop. Unfortunately, many of these companies are passive “shelf companies” with little real business.

Short-term marketable securities are readily salable and usually have quoted prices. May include: trading securities, held-to-maturity securities and available-for-sale securities. They are usually quoted market price when a market exists for the items.

  1. Accounts receivable

When goods are shipped to customers before payment or collection, an account receivable is created. In generally customers are given an agreed-upon time period in which to pay, like 30 or 60 days. However, sometimes some of the company’s customers are struggling and the company cannot collect all its receivables. Therefore, the value of receivables in the balance sheet may not be the same as in reality.

The investor should compare the increase in accounts receivable with increase in sales. If accounts receivables has increased much more than sales, the company cannot collecting bills or the billing times must have been extended. The same thing will be clear also following the days sales outstanding.

  1. Inventories

Inventories are very difficult to estimate for their exact value. Inventories fall into one of the three following categories: raw materials, work-in-process or finished goods. Different companies’ inventories can be very different. The value of other inventories will remain longer and the summer season’s fashion products may lose almost all their value in a short time. If possible, the investor should find out the quality of company’s inventories and, if necessary, adjust its value to the most realistic possible. It should also keep in mind that in the NCAV method we estimate also the company’s liquidation value and in that case inventories may have to be sold at the fire sale value.

The volume of inventories should be compared to the company’s sales and receivables. If the amount of inventories increases considerably compared to sales, it can be a sign that the products do not sell well, but are increasingly staying in storage. Inventory turnover and days inventory indicate the same thing. Inventory should also be compared with cost of goods. If the difference is substantial it is a reliable sign of whether a manufacturer or retail company will stumble.

The valuation of inventories can also be influenced by its structure and the used accounting method. It is good to check how much of inventories are finished goods and how much are work-in-process and what percentage is raw materials. Accounting methods also vary, especially if you invest globally. Normally accountants value inventory using one of the three methods: the first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method and the weighted average method. And they often give a different results as well as making it difficult for companies to compare with each other.

  1. Other Current Assets

Other current Assets like prepaid expenses or income tax receivables constitute usually a very small and unimportant share of current assets. They can generally be accepted as they are in the financial statement.

 

Liabilities

In NCAV method all the liabilities are always reduced from the Company’s current assets as a whole. Basically, liabilities are calculated at face value. However, the investor must beware of any potential off-balance-sheet liabilities. These may include underdetermined pension contributions, possible and unsure litigation costs and contingent liabilities. This kind of stuff is likely to be found in footnotes.

Using the debt properly is a good way to raise the return on capital for many companies, but big load of debt for net-net companies may lead to insolvency.  Net-net companies often have some business problems and if this is accompanied by a large debt burden and possibly a deteriorating general market situation – the combination can be disastrous. Avoid heavily indebted companies. It is more safe not to invest in a company that has a debt-to-equity ratio of over 25%. It’s always better, if we can find companies without debt.

 

Conclusions

Already Ben Graham stated in Security Analysis that realizable value of assets varies with their character. A company’s balance sheet does not convey exact information as to its value, but it does supply clues or hints which may prove useful. The first rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned.

The following schedule of Graham indicates adjusted value of various types of assets in liquidation:

 

% of liquidation value to book value

Type of assets                                                          Normal range                              Rough average

Current assets:

Cash assets                                                               100                                                   100

Receivables                                                              75-90                                               80

Inventories                                                               50-75                                               66⅔

Fixed Assets                                                              1-50                                                 15

You can argue whether these numbers are valid or right anymore today. Perhaps it is not even the most essential question and you should not take these figures precise or exact but rather as a guideline. Every situation is different and every investor should make his/her own calculations based on his/her business knowledge.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s