What should be the value of a company based on assets?

Any company’s worth can simply be worth of its assets. Asset value is the first level of assessment that can represent the baseline of the company’s worth. Additional value a company can create by earning a rate of return more than its cost on the existing and new capital. How do we understand the value of a company based on assets?

Any company has two kinds of assets i.e. current and fixed. Most of the current assets represent their worth. However, fixed assets may not hold the value as shown in the balance sheet.

There are two approaches to address this:

Liquidation value

This is the value assuming the company is shutting down. This approach is suitable when the company is going under liquidation, and the analyst is trying to assess whether to buy distressed assets or not.

Here is a sample balance sheet that we can use to assess liquidation value:

Cash and marketable securities are taken the same as mentioned in the balance sheet. Account receivable will probably not be recovered in total, but we can estimate that we can realize 85% of the stated amount since it is trade debt. Inventory valuation depends upon the type of inventories. More specialized inventory will fetch a lower amount. The same logic applies to plant, property and equipment as well. I have assumed 50% inventory realization and 45% plant, property and equipment realization.

Goodwill will not fetch anything, and deferred taxes will get adjusted with the liabilities.

Account payable and accrued expenses amount to only 2,667. However, after paying for these liabilities, 12,220 will still be left as liabilities. Given the company's condition, if a steep discount is available on debt, investment in debt may be evaluated. However, if a discount is not available, then you should keep yourself away from this company.

Reproduction value

Suppose a company operates in a viable industry. In that case, the economic value of the assets is the company’s reproduction cost, i.e. what a competitor should spend to get into this business.

Cash and marketable securities do not require any adjustment. A new company may not be as efficient in getting the payments from the customer. Therefore, adjusting for allowances in accounts receivable is a better idea. Valuing inventory can be a daunting exercise. Based on the industry, analysis needs to be performed, mainly inventory / COGS, to understand any pilling up of inventory.

Additionally, suppose the firm uses the LIFO method of inventory reporting. In that case, the LIFO reserve is added back because the new firm may not be able to source inventory at last year’s price. Plant, property and equipment may be one item, but they are three. Land usually appreciates; assessing the market value of the land is a better idea. Plant and building use depreciation allowance that may not represent the accurate picture. The competitor has to pay a lot more than what is usually shown on the balance sheet. The adjustment made in the equipment value may be up or down, depending upon the industry, but it is not so massive. The value of goodwill needs to be understood rather than relying on the balance sheet number. Goodwill is an accounting entry, but a company may enjoy a premium due to its reputation. This may be linked with the R&D expense of the company. How many years will the product take to establish its market in a new company's layout?

Most of the quality companies may not be available at asset value levels. However, once in a decade events such Global Economic Crisis of 2008, Pandemic crisis of 2020 may provide window to invest based on the asset value.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

What should be the price for the high quality business?

Before we try to answer the right price point, we must first understand what creates the price of a company or, in other words, the ‘value’. Although there are many valuation approaches used by investment professionals, the one used by Warren Buffet based on Benjamin Graham investment philosophy is the most logical.

Break the value of the company

Element 1: The value of the assets

Financial analysis requires you to have basic accounting knowledge. You don’t have to remember accounting standards, but you have to have knowledge that helps you understand what’s going on in a company.

Any company would have some worth associated with its asset base. Knowing the “asset worth minus any liabilities” is the first element of value for the company. There would be cash, accounts receivable, marketable securities etc., whose value is more reliable. And there would be assets such as plant, property, machinery etc., that may not represent the actual worth. You can take the value of current assets as given in the balance sheet. But the fixed asset value has to be adjusted to represent its current worth. Similarly, current liabilities are assumed to be fair, as represented in the balance sheet. The exact calculation would depend upon whether the company is going into liquidation or you expect the company to exist going forward.

Element 2: Earning power value (EPV)

We always want to look into the future and identify investment opportunities. There is no way anyone can look into the future and be 100% sure that the forecast will become a reality. Another way to look at a company is to assume that the company will not grow. The company continues to exist, but the growth is zero. EPV would indicate the worth of the company in today’s time without any assumptions about the future.

EPV can be calculated as Earnings / Cost of capital

The difference between earning power value and the asset value is the Franchise value of the company. If the difference is positive, it indicates the competitive advantage enjoyed by the company. If the difference is negative, management is not using the firm's assets as it should.

Element 3: The value of growth

The value of growth is the most unpredictable element of value for a company. Unfortunately, many professional investors spend most of their time refining analysis related to the value of growth. A company that enjoys a competitive advantage and has a barrier of entry will enjoy the value of growth. However, companies that do not have any competitive advantage will have a negative value to this bucket. Growth in any company comes when new investments earn a return higher than the cost it spends. Unfortunately, only those companies with a competitive edge can make the return more elevated than the cost over a long period.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

Identifying the ‘economic’ moat

In 2007, Warren Buffet wrote in Berkshire Hathaway's letter about the ‘economic moat.’ Just like a castle has a moat that surrounds the castle with muddy water, crocodiles, etc. This moat prevents the enemy from entering the castle. So likewise, an economic moat provides some sort of protection of business cash flows.

Economic Moat

There is an excellent distinction between the competitive advantage and a wide economic moat. A competitive advantage is an edge that allows a business to earn better margins over its competition. In comparison, an economic moat is an advantage that lasts for a long-time.

Here are few “indicators” to help us identify economic moat:

1. Intangible assets: Fanatically loyal customers. Profit margins or cash returns on invested capital consistently exceed the industry average or those of their competitors—successful companies with high priced, quality products or services for decades, supported by their brand strength. Example, Asian Paints, Colgate.

2. Customer Switching Costs: If a customer of the product or services is required to spend more money or time for the closest substitute. Example, Bloomberg.

3. Networks Effect: Networks that become more useful as more people join. Example, Facebook.

“All intelligent investing is value investing, acquiring more than you are paying for. You must value the business to value the stock.” – Charlie Munger

You may be willing to pay a premium for these high equal high-quality, but you still can’t pay any price and incorrectly assume it’s a fair price.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337