FFB-Post 21
In the world of investing, one of the key principles that seasoned investors follow is to purchase assets at a price below their true value. This strategy minimizes risk and maximizes potential gains. One such method to evaluate whether a stock is undervalued is Benjamin Graham’s “Net-Net” valuation method. This approach was developed by Benjamin Graham, widely regarded as the father of value investing, and was one of his preferred ways to identify safe investment opportunities.
Understanding the Concept
The idea behind the Net-Net valuation method is simple: Buy a stock at a price lower than its liquidation value. But what does this mean?
Liquidation value is the amount of money a company would have if it stopped all operations, sold all its assets, and paid off all its liabilities. In essence, it’s the value that would be returned to shareholders if the company were to be dissolved.
How Does Net-Net Work?
To purchase a stock below its liquidation value, you need to do two things:
- Calculate the Liquidation Value: This is the most critical step. You need to figure out what the company’s net current assets are. Net current assets represent the value of the company’s assets that can be quickly converted into cash, minus its liabilities. The formula is straightforward:
Net Current Assets (NCAV) = Current Assets – Total Liabilities - Buy the Stock at a Margin of Safety: Graham’s rule of thumb was to buy the stock at two-thirds or less of its NCAV. This gives you a significant margin of safety, ensuring that even if the company faces some trouble, your investment is protected.
Step-by-Step Guide to Using the Net-Net Method
Let’s break it down further with a step-by-step guide:
- Check the Balance Sheet: Start by looking at the company’s balance sheet. Identify the total current assets and total current liabilities.
- Total Current Assets: These are assets that can be converted into cash within a year. Examples include cash, accounts receivable, and inventory.
- Total Current Liabilities: This includes everything the company owes, such as loans, accounts payable, and other obligations.
Subtract the total liabilities from the current assets to get the Net Current Asset Value (NCAV).
2. Calculate NCAV Per Share: Once you have the NCAV, the next step is to determine the NCAV per share. This tells you how much of the net current assets belong to each share of the company. To calculate this:
NCAV Per Share = Net Current Assets \ Total Number of Shares Outstanding
The total number of shares includes all shares held by shareholders, including institutional investors, banks, employees, and company management.
3. Apply the Margin of Safety: Graham advised buying the stock at a price that is two-thirds or less of the NCAV per share. For instance, if the NCAV per share is ₹100, you should aim to buy the stock at ₹67 or less. This margin of safety is essential because it provides a buffer against unforeseen events that could impact the company’s value.
Why Is This Method Conservative?
The Net-Net method is considered highly conservative. By purchasing a stock at such a significant discount to its liquidation value, you are essentially paying for the company’s most liquid assets and getting the rest of the business for free. Even if the company were to shut down, you would still have a good chance of making a profit.
However, it’s important to understand that this approach, while safe, can sometimes limit your opportunities. Companies that are trading below their NCAV are often in distress or have significant challenges, which is why they are so cheap. This means that while you have a margin of safety, the potential for growth might be limited unless the company can turn things around.
The Risks of the Net-Net Approach
Even with a margin of safety, the Net-Net approach is not without risks:
- Undisclosed Losses: Companies might not always disclose all their losses upfront, meaning their assets could be worth less than reported.
- Asset Deterioration: Over time, assets might lose value faster than anticipated, especially if the company is in decline.
- Management Issues: Poor management can lead to a rapid decrease in NCAV, making the investment less secure.
Because of these risks, it’s crucial to select companies that you are confident in and that show potential for recovery or growth.
Conclusion
The Net-Net method is a powerful tool for value investors looking to minimize risk. By focusing on stocks that are trading below their liquidation value and buying at a significant discount, you can protect your investment and potentially achieve solid returns.
However, as with all investment strategies, it’s essential to do your due diligence. Not all companies will be suitable for this method, and even those that may come will have risks that need careful consideration. The key is to use this method as part of a broader investment strategy, combining it with other valuation techniques to ensure a well-rounded approach.
In the next post, I’ll explore another popular valuation method: the Price-to-Book (P/B) ratio. Stay tuned to continue building your investment toolkit!
For Post 22 – Click Here -> Price-To-Book Value