Net-Net Stock Strategy: Fully Explained
Quick Summary In the 1934 edition of Security Analysis, Graham wrote: "The first rule of calculating liquidation value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount. The value to be ascribed to the assets, however, will vary according to their character."
The NCAV formula is a very conservative way of calculating liquidation value because we exclude the uncertain value of long-term assets. But current asset values also vary somewhat from their stated balance sheet figures. As mentioned, the cash and equivalents figure is about as certain as balance sheet values get. While short-term investments vary slightly in value, some receivables may remain uncollected, and inventory values can fluctuate much more due to breakage and obsolescence. Add to the mix prepaid expenses, some of which may not be refundable, and it seems you can't base a solid assessment of liquidation value on anything besides cash.
Because Graham realized this problem, he offered two solutions. He noted that while the value of receivables, inventory, and so on may shrink during liquidation, the value obtained through the sale of long-term assets would, on average, step in to take care of these shortfalls. While net-net investors purposefully exclude long-term assets during the valuation process, vehicles, office chairs, and warehouses still have value, albeit an uncertain amount.
Graham knew better than to assume that long-term assets would completely make up for shrinkage and therefore made it clear that this phenomenon would occur on balance. While, in some cases, the value of some companies long-term assets would fail to make up for current asset deterioration, investors would find that other companies possessed long-term assets that were much more valuable than expected. In this way, over a large number of securities, shortfalls would be balanced by long-term asset value.
Graham's second solution gives the analyst a purpose for being. Rather than leaving it to the value of long-term assets to step in and fill in the gaps, an investor could simply discount the current asset accounts and estimate the amount of shrinkage that could take place. Discounting the accounts means an even larger margin of safety, by allowing for more shrinkage in value before liquidation value estimates are impaired. Graham went so far as to include long-term assets in his calculation for this approach, though he first heavily discounted their value.
Both Graham and Buffett used this approach when selecting net-nets for their own portfolios in the 1950's and 1960's. Both would also apply their business knowledge and experience to determine the best discount rate possible. Modern investors, on the other hand, don't worry too much about trying to estimate current asset impairment. Instead, they tend to take a standardized approach derived from Graham and Dodd's Security Analysis textbook.
In the book, Benjamin Graham suggested a range of values for various balance sheet accounts when calculating net-net working capital. The analyst needs to determine the exact discount applied to each balance sheet account based on his knowledge of the industry. I've taken the following information from the sixth edition of Security Analysis, based on Graham's work in the 1930’s.
In table 2, Graham specifies that receivables, for example, are to be discounted by between 10 and 25%, based on the nature of the business, customer, marker conditions, and other relevant facts. Inventory, likewise, is to receive a 25 to 50% reduction, and long-term assets are to be marked down between so and 99%.
These multiples reflect the dependability of each asset class. The value of cash on the balance sheet is usually very accurate, while inventories can vary quite a bit. Rather than assess the relevant facts, investors today have simply opted to apply the average figures on the right side of the table, assuming that this additional conservatism would yield better returns. For example, when calculating NNWC, an analyst applies the following multiples to each relevant current asset account.
Cash x 1
Receivables × 0.8
Inventory × 0.67
This seems simple enough, but Graham misses a couple of accounting entries that the modern-day security analyst has to deal with: short-term investments, prepaid expenses, tax receivables, and current tax assets.
The real-world value of short-term investments can vary somewhat from their carrying value, depending on both the nature of the investments and current market conditions. Short-term government bonds usually only vary slightly in value compared to mutual funds or stocks. Here, analysts have to use their best judgement on probable changes to the values since the most recent balance sheet date. Even if there's been no change in asset values from the most recent reporting period, broker commissions have to be factored in when liquidating the account. Some investors have applied a blanket discount of 10%, or a × 0.9 multiple to the value of short-term investments on the balance sheet. This seems too aggressive when accounting for broker commissions today, but it does allow for some deterioration of the short-term investments account.
Short-term investments × 0.9
Many investors just mark prepaid expenses to zero, assuming that they're merely an accounting entry and carry no real value. This is a bold assumption. If you think about those times in your own life when you prepay for goods and services, you could probably get at least a partial refund most of the time if you request one. Again, industry or insider knowledge is crucial for assessing actual realisable values, but it seems reasonable to assume that a liquidator could retrieve 50% of the company's prepayments. While certainly not exact, it's at least more accurate than assuming prepayments are worth nothing or that the full value could be refunded.
Prepaid expenses × 0.5
Tax receivables are tax refunds: money owed to the company by some state tax authority. It's fair to say that other than in exceptional cases, the value of these assets is certain and investors do not have to discount the account in question.
Tax receivables × 1
Current tax assets are another matter entirely. Unlike tax receivables, current tax assets are an accounting entry and the value in question cannot be collected by the company. They usually stem from prepaying taxes owed by the firm.
Current tax assets × 0
Adding all of the above to Graham's original figures, the standardized NNWC
Net-Net Stock Strategy, Benjamin Graham's
Source: 'Benjamin Graham's Net-Net Stock Strategy' / Harriman House