Although Benjamin Graham’s Net Current Asset Value Method is balance sheet based analysis method, it is wise to look at some other figures also. The financial statements contain a lot of information that may be helpful before we make a final decision to purchase a stock.
Useful information can be found from long term assets of balance sheet, from income statement and cash flow statement and even current assets to total liabilities ratio can tell a lot about the inherent of the stock.
Long Term Assets
Although long-term assets are not taken into account when calculating the net current asset value of a company, their meaning cannot be completely ignored. Especially when calculating the company’s margin of safety, significant fixed assets can reduce the risk of such a quantitatively cheap stock.
Some companies may have great wealth in their fixed assets (property, plant and equipment). The quality of assets is decisive in calculating its value. Sometimes the case is that the real value of a property or buildings is significantly underestimated in the balance sheet. Landownership or building acquired long ago in an important area of a large city can be today much more valuable than its purchase price in the balance sheet. The realization value of highly liquid fixed assets may in fact be much larger than the value of obsolete inventories.
Also companies of new industries (eg high technology companies) may have intangible assets such as staff expertise, customer relationships, brands and patents to be the largest asset item. For this reason, an investor should always make an estimate of the real value of company’s long-term assets.
As said, long-term assets do not affect the net current asset value of the company. They may, however, provide additional information before the final purchase decision, and in a positive case, reduce the risk of investment and increase the margin of safety.
In general, the income statement and earnings per share are the most important source of information for analysts and investors when assessing going concern companies. On the other hand, in the net current asset value method Income statement numbers does not directly affect the valuation of the company. However, they can provide a lot of information to the investor about the company’s quality.
It is always advantage, if the company has been able to generate profits at some point in its past. The more profitable years over the past ten years the better. A company that has only produced a loss is a great opportunity to become perennial NCAV stock, stock that always seem to trade below its net current asset value. When investing in such a company, the investor must be able to see a clear catalyst (activist investor, new management, reorganization or new growing product line) of business turnaround.
The company’s gross margin, operating margin and net margin from the income statement show how profitable the company is and how competitive it is in its industry. In particular, the change in these figures over the longer term tells us the direction in which the company is going. Many net-net companies are operating in heavily competing business and have suffered losses. In that case, the profit margins are seldom at a very high level, but their improvement may be the signal of a positive change.
As companies are easier to manipulate the income statement, investors should then always look at the cash flow statement also. Cash flow from operations and free cash flow figures should confirm the conclusions we have made on the basis of the income statement and company’s earnings. If the figures find are illogical or inconsistent, then the investor should find out the reason. Changes in quarterly cash flow statement may anticipate the company’s future direction even before the figures are shown in the income statement. A positive change in operational or free cash flow may appear in the company’s bookkeeping before the change in market value of the stock.
Current Assets to Total Liabilities Ratio
This ratio is relevant when we evaluate the possibility of increasing the value and the risk of a decreasing the value of a share.
- Current assets to total liabilities ratio is low
If current assets to total liabilities ratio is low, then the opportunity for a share price appreciation is huge, but so is the possible decrease of the value also. We assumed that net-net company has $100 in net current asset value and $90 in total liabilities. Then current assets to total liabilities ratio is 1.11. If you pay $6 a share – which is 60% of NCAV for that stock – and the company grows current assets by 10%, it means the net current asset value of the company has risen to $20. In this case investor who has paid $6 for the stock can achieve a tremendous 233% increase in value.
Unfortunately, the same thing works in the opposite way. A 10% decline in current assets eliminates all of the company’s net current asset value. If the company is losing money and doesn’t have access to long-term financing it could go to zero. So a stock that cost less than its NCAV (in this case anywhere from $6 to $10) could very quickly be worth either $20 or $0 a share.
- Current assets to total liabilities ratio is high
Instead, if the ratio of current assets to total liabilities is high, then the upside potential is more limited, but the downside protection is also considerably higher. Let’s assume now that current assets of the company are $11 a share and total liabilities are $1 a share. In this case, the ratio of current assets to total liabilities is 11 and the net current asset value of the company is the same $10 as in the previous example. But now, the current assets increase by 10% (to $12.10 a share) will lead to NCAV of 11.1 a share. If you could buy a company again with $6, then your upside is now 85%. Significantly less than the mind blowing 233% in the previous example.
On the other hand, a 10% decline in the company’s current assets would still leave the company with $8.90 in net current assets. That means still nearly 50% upside for the investor. You can easily see that the ratio of current assets to total liabilities really matters. A high ratio is more favorable for the investor and gives better margin of safety. That’s the way to find a Benjamin Graham bargains.
Look at also a great article of Geoff Gannon on this last topic: https://www.gurufocus.com/news/167125/how-to-pick-solid-netnets