As the title suggests, Sven Carlin had a long list of conceptual issues to address in “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment.” We began that list with a discussion of tools one and two, focusing on the second, net present value. We will now summarize his thoughts on liquidation value and market price valuation.
Tool 3: Liquidation value
Liquidation value is defined as the difference between the net value of tangible assets and all liabilities. According to Carlin, it provides a strong margin of safety because it shows the value left to shareholders if the company ceased to be an ongoing entity.
From another source, we learn there are usually four levels of valuation for business assets:
- Market value.
- Book value.
- Liquidation value.
- Salvage value.
As may be obvious, the list goes from highest valuation to lowest valuation, with liquidation value being less than book value, but more than salvage value.
Carlin noted that whether liquidation value is useful to value investors will depend on circumstances. For example, these types of business exits may occur:
- Fire sale.
- Slow wind-down.
- Selling business units.
Each of these circumstances would dictate its own individual response since the potential outcomes vary widely.
In assessing liquidation value, the valuation of the current market will also be an issue. For example, the S&P 500 was “extremely” overvalued in 2018 and had a price-book value ratio of three to one. Thus, we would expect market values to be roughly three times higher than book value, and three-plus times higher for liquidation value. In bear markets, we might look for much lower ratios.
Carlin explained that intangible assets are usually excluded because they are mostly goodwill, which he defines as how much a company overpaid for an acquisition. He added there is no real value in goodwill and that is an accounting gimmick. The value of goodwill becomes extremely high in bull markets and extremely low in bear markets.
Book value helps determine liquidation value, but investors should not necessarily take book value at face value. The author wrote book value represents the accounting value and not real-world value. For example, a company depreciates a building each year and, after a few decades, the balance sheet value will likely reach zero. But if the company put the building up for sale, its real estate market value would likely be much higher.
Debt considerations may also be a factor, particularly when it comes to pension fund liabilities, since they are forward-looking and subject to numerous variables. For example, Carlin cited the possibility of a company expecting to achieve an average return of 7% per year over the next 20 years, while current, well-diversified portfolios are returning an average of 3%.
To put this all into context, Carlin wrote, “The main point in determining liquidation value in order to calculate a margin of safety price is to look beyond the numbers on the balance sheet and estimate the actual fair value of the assets owned by the company.”
He went on to call liquidation value the only “real value” in investing because it restates all asset values to cash. With that foundation, an investor can proceed to the next step of adding the value of future cash flows.
Value investors may also find it useful when assessing a company that has been hurt by a raft of bad news (think of Wells Fargo WFC as a recent example). Liquidation value provides a worse-case scenario value. When the worst-case liquidation value is higher than the stock price, there may be an investment opportunity with limited downside.
To calculate liquidation value, Carlin recommended the following steps:
- Determine the fair value of the assets; goodwill usually can be dismissed immediately, but getting fair market values for assets such as buildings and inventories will require time and effort.
- Discount the fair value by 30% to 50% in case of potential fire sales.
- Subtract the company’s liabilities.
As Carlin pointed out, the more investors know about a company and how it has grown over time, the more accurate your calculation of liquidation value is likely to be. He added that if a company has used historical cost accounting and has not revalued its real estate properties, there may be huge hidden value.
Tool 4: Stock market price
In some uncommon situations, value investors will depend on stock market values to assess intrinsic values. According to Carlin, “this is only in specific cases where a unit of a business is valued by comparing it to similar businesses traded on the stock market or for the valuation of an investment company.”
He uses the example of a holding company made up of businesses in different sectors or industries. It might best be valued by comparing its business units to those of comparable companies. He cautions, “Of course, one should only make a purchase when the current stock price is significantly below the comparative value in order to have a margin of safety.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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