In Investment textbooks, we only briefly discuss asset-based valuation, like book value, and could not wait to move to income-based valuation, like dividend growth model, free cash flow model or Price-earnings ratios. It makes sense. Income-based valuation is considered superior to asset-based approach. As I told my students, asset-based valuation looks at what it cost to build the business in the past. Income-based valuation looks at what the business generates in the future. We all know that stock valuation should be based on present value of future cash flows, not past cash flows used to build the business.
However, in a number of situations, asset based valuation is superior, especially for a value investor.
Consider a hypothetical company X:
X generates an annual net income of about $100 million, with no growth. Using income-based valuation and assuming a 10 times PE ratio for no growth company, it implies a $1 billion market value. However, if you zoom in to examine its balance sheet, you find this $100 million net income is generated by two distinct resources: A $1 billion net cash pile that produces a mere $20 million interest income (given current low interest level, this should not be a surprise) and a core business with a book value of $800 million that generates $80 million earnings. $1 cash should have a market value of $1. After all, all cash is created equal. The $1 billion net cash should be valued at exactly $1 billion. Plus the book value of $800 million of core business, the whole company should be worth $1.8 billion instead of $1 billion.
What’s wrong with the value-based valuation here? The answer: the discount rate you use.
In theory, income-based valuation should give you the same number, if you do it right. In this case, the $100 million net income should be discounted at a rate lower than 10%. The portion of income generated by cash should be discounted at risk free rate, if the cash is used to by treasury bonds, as many cash rich companies do now. Using a 2% risk free rate, the discount rate for the company, or the weighted average cost of capital should be: 2%*(1000/1800)+10%*(800/1000)=5.5556%. This cash adjusted discount rate should help you arrive the same valuation as asset-based approach: $100/5.5556%= $1,800 million.
Practically, most investors, including many professionals, fail to make such adjustment for net cash or net debt. The mistake would be painful when valuing a company with a lot of cash and earns extreme low interest. The list of such company is long: Apple has $137 billion net cash (cash minus total debt), higher than its total book value and the market value of most Fortune 500 companies. Yahoo has $8.5 billion cash, probably higher than the value of its core business. Microsoft has $71 billion net cash. Sina has $1.2 billion net cash, more than 50% of its current market value. Investors should either subtract out the cash and cash generated income to calculate the enterprise value, or lower the discount rate.
On the other hand, you have a list of companies with significant net debt (cash minus short and long term debt): $25 billion for IBM, $131 Billion for AT&T (compared with a net cash of $6.7 billion for Verizon), and $23 billion for Time Warner Cable. The higher leverage increases the EPS, particularly in this low interest environment. An income-based valuation model without proper adjustment for discount rate is likely to underestimate the value of the debt and overestimate the value of the company.
In short, an asset-based valuation might help you to discover under-valued stocks that looks less appealing based on current earnings. The company might eventually use the cash to buy back its stocks, increase its dividends or invest in its business. Eventually, the ignored assets on balance sheet will show up on income statement, and rewards those stock investors who see this coming at the beginning.
Disclaimer: the numbers, analyses and opinions here are subject to errors and human biases. Those opinions cannot substitute your own rigorous research. You are responsible for your own investment decisions. I own some of the shares mentioned in the article.
