Tony Boden turns to assets as a tool for valuing companies.
In my previous article I touched on valuing companies based on their earnings, now I want to look in more detail at valuing companies based on their assets.
The conventional measure here is to compare the market value of the company (P) with the ‘Book' (or Balance Sheet) Value of its assets (BV)
If the resulting ratio P:BV is greater than 1 then the company is valued at more than its assets, however if the ratio is less than 1, it is valued at less than its assets and superficially at least may appear to be undervalued.
A more robust measure is to exclude "Intangible" Assets (particularly ‘Goodwill') from the Book Value to arrive at the Tangible Book Value. Without going into detail, the ‘intangible' label gives the indication that the value of these assets may be less robust.
Investors often consider a low PBV (or better PTBV) as offering a margin of safety should the company's trading deteriorate. This is certainly true to a degree, but it would be a mistake to overestimate this degree of protection if the company were to cease trading.
Many of the assets may not actually sell for their ‘Book Value' particularly in a ‘fire sale'. (Just how much is a second hand widget making machine really worth if nobody wants to buy widgets anymore?) . Equally there may be significant liabilities that are not typical shown on the balance sheet (for example the cost of staff redundancies or the costs of liquidation are rarely considered in the balance sheet).
However, one would not usually be investing in companies that are likely to go bust, and it least a strong balance sheet does give some degree (if only partial) of protection should the worst come to the worst.
The balance sheet also gives some indication of how much it might cost a competitor to enter the market. However, this may not be particularly helpful given that often the real competitive advantage for a company is customer loyalty and brand recognition, and these are usually not reflected on the balance sheet.
Equally important is to consider the company's liquid assets and especially net cash or net debt. Whilst corporate debt is not automatically a bad thing -- it can be an efficient use of capital -- it is a risk factor to consider.
Companies with significant amounts of debt may struggle to survive any downturn in trading. Companies do not go bust as a result of not being able to pay dividends to shareholders, but they do go bust as a result of not being able to pay off their debts.
Some investors will use ‘interest cover' (the ratio of earnings to required interest payments) to measure the ‘riskiness' of a company's debt -- however I believe that this can give a false sense of security. A downturn in trading may not just cause a small reduction in profits, it may well result in a loss and an inability to pay loan interest irrespective of past earnings levels.
For some investors the approach will be to totally avoid companies with net debt. This is quite an extreme position but probably not a bad place to start. Consideration of whether debt levels present an acceptable risk is probably best left for when you have developed confidence is assessing and valuing companies.
So we have now taken a brief view of how to look at company valuations based on earnings and assets. To round up this series, in the next article I will briefly review how to get the data needed and how to begin to apply these ideas.
More:
How To Value Companies, Part 1 | How To Value Companies, Part 2 | How To Value Companies, Part 4
