The average investor focuses upon the present and future cash flows of a business while paying relatively little attention to value of its assets. At first glance the notion seems to be an extension of common sense; after all, who would want to buy a business that did not make money?
If I am looking to purchase a private business from another individual I am not likely to buy a bar, restaurant or retail store that perpetually loses money. In the event that I make such a purchase it would appear to the average person that I am either one of the world's worst entrepreneurs or else I am privy to some information that the average person does not fathom. In reality, I am probably just attempting to purchase the assets of the business at a discount to their intrinsic value.
Investors who focus upon purchasing stocks which are discounted in terms or their asset value, rather than the perceived future cash flows of a business, are generally perceived as contrarians. Many times they are merely making a conservative long-to-medium-term investment which holds a significant margin of safety.
Analyzing the Asset Value of a Mythical Home Furnishing Company
Let's say that I wish to buy the business, land and property of a failing retail store that sells imported home furnishings. The business has not showed a profit in the last five years and the current owner is now faced with the possibility of taking on a large amount of debt in order to refinance the business costs of running a losing proposition. The business profitability has turned negative for a variety of reasons including: its poor location, the housing bust and the introduction of lower cost competition in the community.
Furthermore, the business contains a warehouse full of inventory, some of which is finished and some of which is stored as replacement parts that are used to repair damaged furniture and other products that the company has sold to past customers. Additionally, most of the inventory has been written-down as obsolete to conform to accounting rules.
The warehouse also contains a large amount of equipment which was purchased 10 years ago to use when the business had a thriving repair business. The equipment is in excellent condition since it has hardly been used to the past five years, although it has been fully depreciated on the company's balance sheet.
Let's say that the assessed value of the land and property has remained stagnant in the recent years and the owner has seen countless other business owners relocate to other areas of the city. Unlike the owner of the aforementioned business, most of area businessman have not been encumbered by the burden of property ownership and are free to move their stores to better areas as soon as their leases allow; however, the liability of ownership is about to turn into a significant asset.
Let's take this tale a little further, suppose that the city is in the process of redeveloping the area and the city has decided to allow Walmart to open a location across the street from the struggling home furnishings company. Almost overnight, the value of the land on which the business is located is suddenly worth a large premium. That said, it may take potential buyers an extremely long period to recognize that fact.
Think that such an event is far-fetched? Take the case of the Tropicana Hotel and Casino located on the south part of the Las Vegas strip. Originally constructed in 1957, the Tropicana was once an oasis known as the "Tiffany of the Strip," existing far away from its other rivals on legendary Las Vegas Blvd. Unfortunately, the shine wore off the casino in less than a decade and as the casino aged, its profits and real estate value declined precipitously.
In the interest of brevity, I will not discuss the casino’s mob ties and fast forward to the early 2000s when the Tropicana's asset value once again skyrocketed. You see, the once desolate corner of Las Vegas Blvd. and Tropicana Ave. was soon to become the highest populated hotel area in all of Las Vegas following the relocation of the MGM Grand Hotel and several other casinos who had decided to construct their hotels on the corner.
At that point in time the casino was owned by Aztar (AZR). Such information is easy for me to recall since AZR was soon to become my greatest investment blunder. I became interested in Aztar after my former broker expressed the belief that the business would eventually be sold. That recommendation coupled with the fact that Mario Gabelli had mentioned the stock on CNBC had piqued my interest in buying some shares. That is how this tale of woe began. As I recall, I purchased shares of the company as low as four dollars per share and as high as seven. The stock never had shown much in the way of operating earnings but occasionally spiked due to buy-out rumors. I believe I held the stock for several years, eventually selling it for a meager profit.
In the late summer of 2006, Columbia Sussex Corp. won the bidding war for Aztar paying $54 a share for the company. Ironically, the deal was finally consummated at virtually the peak of the Las Vegas property bubble.
With that temporary diversion completed, I will now return to our mythical home furnishing company. For the sake of simplicity, suppose that the tangible equity (the sum of the company's assets minus liabilities less intangibles) is five million dollars. How should one assess the value that a private buyer should pay for the business, land and property?
Classic value theory suggests that a business should be valued as a function of its replacement value, plus its business value, plus it potential growth. Clearly, a money losing business does offer much in the way of growth, in reality it might actually hold a negative business value if its prospect's of turning a profit in the future are remote. That may be the case with our hypothetical home furnishing business. On the other hand, the business may merely be languishing in a cyclical trough that is certain to end as demand for housing increases.
Our hypothetical example is now getting more complicated by the minute. It seems that the value of the business is not at all related to the sum of its cash flows. Rather, the value of the business is almost entirely a function of its tangible and intangible assets, some of which are not reflected in the companies' balance sheet. Specifically, much of the company's inventory and equipment is written down to zero, the value of the property and land is understated (particularly with the opening of a Walmart store), and finally, since the business has been losing money for five years it almost certainly has accrued significant net operating losses (NOL) which can be used to offset future taxes on it profits.
If I am able to buy this business at its stated book value (five million dollars), I have likely made a good purchase. If I am able to buy the business at a 50% discount to its stated book value (2.5 million dollars) then I have made an outstanding purchase so long as I am able to realize its underlying value. The latter part is a function of my management skills and my business acumen.
The asset value of the business is far greater than its stated book value due to the understated value of its land and property, the understated value of its inventory and equipment, the potential tax saving value of its NOLs, and the likelihood that the operating earnings of the business will increase as the housing economy improves.
Methods of Extracting Value from Asset Plays
The problem with investing in discounted assets is that the discount can remain intact for an extremely long period if the management is not interested in recognizing value for the shareholders. In some cases the managers have no vested interest in extracting value from an undervalued stock. Maybe they hold little in the way of company ownership and draw a premium salary. Conversely, they might own a controlling interest in the company and have no interest in selling the business; they may prefer to pass it on to their offspring and continue to draw hefty compensation.
As an aside, such concerns can sometimes be uncovered by studying the proxy statement of a company. For instance, excessive compensation coupled with a controlling interest in a business is frequently a red flag when one is considering purchasing shares in a company. On the other hand, as in the case of Buffett, a controlling interest coupled with a reasonable salary can indicate that the management is shareholder friendly.
Frequently, stocks that are trading at substantial discounts to their book value receive buy-out offers from their competition. Many times it is more efficient to assimilate a business than to reproduce its assets.
The following is a brief discussion of how management can enhance shareholder value if a buy-out offer or stock appreciation does not transpire.
A leaseback is transaction where one sells its land and property and then enters into a long term lease so they are able to continue to conduct business on the site.
In the case of our mythical business, the owner might consider selling the real estate and leasing back the land and property should he wish to continue to conduct business at the same location. By doing so he could recoup a large portion of his investment as well as utilizing the excess cash in a more efficient manner.
Other alternatives would include moving the business and redeploying the existing land into rent producing parcels or selling the home furnishing business outright while maintaining the property for rental income. If the business was worthless one might also consider divesting the land and property for capital gains.
Liquidation of Assets
If the owner deemed the business had no future earnings power he would be wise to liquidate all his assets (with the possible exception of the land and property) and monetize them as quickly as possible. If this is the case, the sale price of the business assets is likely to bring significantly less that the stated book value of business. In the case of our mythical business the exception would be the windfall brought about by the increase in the property value of the land.
Spinning Off Assets
A spinoff[ is defined as the separation of subsidiary, business, or other part from the parent company. Sometimes the sum-of-the-parts is greater that the whole and spinning off certain businesses can unlock shareholder value.
Spinoffs are desirable if they can be conducted in a tax efficient manner, particularly if an underachieving portion of the business is dragging down the market's perception of the value of a company.
In the case of our mythical business, the new owner might decide to separate the home furnishing business from the real estate in a tax efficient manner. This might benefit him if he wished to sell either the business or the real estate as separate entities.
Long-term value can be enhanced by properly executed share buybacks. Such buybacks should only be executed if the intrinsic value of the assets (or future cash flows for earnings investors) is significantly discounted. Unfortunately, buybacks are frequently used to control share dilution in companies that choose to provide excessive management compensation in the form of options.
In the case of our mythical company, imagine that the business was owned by several investors. Buying out an investor who was willing to part ways with his percentage at a significant discount to the book value of the business would provide the remaining owners with excellent long-term value.
In Conclusion Discounted Assets Provide a Margin of Safety
Warren Buffett has described margin of safety as the three most important words in investing. For most investors, a sufficient margin of safety is more easily discerned by evaluating the assets of a business rather than projecting its future cash flows. Simply stated, the average investor is frequently better served by focusing upon assets rather than earnings. That notion may not conform with common sense but it explains the success that balance sheet investors frequently exhibit.
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