The common stock of a company becomes worthless if two criteria are met.
1) The company runs out of cash to settle liabilities currently due. – technical insolvency
2) The market value of all assets is less than the sum all liabilities. – bankruptcy
By inverting, we may conclude that on its way to zero, a stock meets two barriers. These barriers are a source of downside protection.
A stable source of cashflow that is sufficient to pay down debt under the worst of conditions. If a company consistently generates enough cash to pay down debt after spending on maintenance, the common stock may be compared to a high quality bond or a treasury bond. If the earnings yield of its stock exceeds the yield on premium bonds, the gap may be considered a margin of safety.
In practice, the point is not lost on banks and other lenders. Even in 2009 such companies were able to refinance debt that came due. The common stock of Moodys (NYSE:MCO), Coca Cola (NYSE:KO), Altria (NYSE:MO) and Heineken (HINKY) all benefit from this first barrier. Moodys is an example of a company with liabilities that exceed the value of its tangible assets. It’s barrier I that holds the stock above zero.
The market value of all assets exceeds the sum of all liabilities. Should such a company be forced into liquidation, there should be some money left for the owner of the common stock after all debt has been settled. If the market cap of such companies is less than the net value of its assets, the difference offers a margin of safety.
In practice, such companies are often taken off the market by buyers with a better plan for the assets. In some cases, management may do a partial liquidation and return cash to shareholders. There are simple rules of thumb to determine the market value of current assets such as cash, inventory and receivables. Some companies have other liquid assets that require carefull inspection to determine their market value. Steinway (NYSE:LVB) owns some valuable realestate in New York and Aircastle (NYSE:AYR) owns planes that could be sold at a profit tomorrow. Movado (MOV) has inventory that may be worth less than book value but even then, does have some value.
Belt & suspenders
There are stocks that are on the right side of both barriers Jakks (NASDAQ:JAKK) trades at a modest premium to net assets and Conns (NASDAQ:CONN) trades at a meaningfull discount. Both generated enough cash at the worst of times to settle liabilities as they came due. Burlington (BNI) too could probably have been liquidated at a profit and consistently generates excess cash.
Then there are stocks that are not clearly at the right side of any barriers. Palm (PALM) is an example of a stock without a reliable source of cash that also trades at a meaningfull premium to net assets.
Profitable NCAVs are rare; the market assumes both barriers will break.
Beware of unquantified liabilities. The Wellcare investigation and the USG asbestos litigation are examples of liabilities that could have broken both barriers at once. It is rare for equity to be wiped out that way though.
There are other ways of avoiding losses. One can set up stop loss orders and practice diversification. These techniques may possibly shield the investor from losses, they will certainly generate profits for the broker.
There is no way to account for dishonest management.