Valuation Series 2: the Net-Net Valuation

Ben Graham developed two types of stock valuation methods. The first type, featuring the Graham formula (discussed in Valuation Series 1), focuses on a company’s earning capability and future growth. One of the drawbacks of this approach is that the valuation formula relies heavily on accurate estimation of future growth rate. As the COVID-19 pandemic has shown to us, even profitable companies is not guaranteed to survive when systemic risk hits.

The other type, Net-Net valuation, adopts a more conservative approach by focusing on a company’s liquidity value. In other words, this method assumes the worst scenario for a company and estimates its worth if it liquidates (sells) its assets immediately. The idea is that a stock is undervalued if its market price (capitalization) is lower than the worth of its assets. One advantage of Net-Net approach is that it doesn’t rely on estimation for the future. Rather, it focuses on the proven information that is available right now.

Stocks meeting Graham’s net current asset value criterion outperformed a broad market average – and notably. Not only did the strategy return continued superior performance, it also had fewer losing years.


The Net-Net Valuation

The Net-Net valuation evaluates a company based on its ability to accumulate cash. To add a layer of caution, the Net-Net approach only count cash, cash equivalent, and short-term liabilities in valuation while intangible assets such as intellectual property, brand name are ignored (if an undervalued company also has valuable patents or brand name than it only works in investors’ favor). The Net-Net valuation has two definitions. One focuses on net current asset value (NCAV) and the other on net-net working capital (NNWC).

Net Current Asset Value formula

NCAV = (Current Assets – Total Liabilities – Preferred Stocks) ÷ Outstanding Common Shares

  • Current Asset
  • Current asset is any asset that can be easily and quickly (in one year) converted into cash. It includes cash, short-term investment (e.g. treasury bills or bonds), account receivable (the money that customers owe to a company and that is be expected to be paid in a year), and inventories. The assets that can’t be converted to cash quickly such as land, buildings, equipment, intangible assets (e.g. patents, copyrights) are considered long-term assets.

  • Total Liabilities
  • Total liability is the total amount of debt of a company. It includes both current liabilities (need to pay within a year) and long-term liabilities (debts that are due later than a year). The debts could from rent, utilities bill, corporate credit card bills, unearned revenue (money prepaid by customers for service or goods to be provided in the future).

  • Preferred stocks
  • Preferred stock is part of a company’s shareholders’ equity. Shareholders’ equity is the difference between total assets and total liabilities the reason is that a company’s assets are either owned by its creditors or owners (shareholders).

    A company can issue preferred shares and common shares. The main difference between the two types of shares is that preferred shareholders have priority over common shareholders in claiming company assets, such as dividends. In the case of company liquidation, company assets will be paid to (1) creditors, (2) bond holders, (3) preferred shareholders, and lastly (4) common shareholders. For this reason, preferred shareholders’ equity needs to be deducted from current assets in order to find out the amout of assets available to common shareholders. On the flip side, in exchange for their privilege, preferred shareholders do not have voting rights like common shareholders do.

  • Outstanding common shares
  • After deducing total liabilities and preferred stocks from current assets, we get the net current asset value of a company. Technically, we could just compare with the company’s market capitalization. But, to make evaluation even simpler, we could divide the value by the number of outstanding common shares, which is the number of common shares that are tradable in the market. The final result, NCAV per share, then can be easily and intuitively compared with stock price of a company.

    Information about the items in the NCAV formula can be found in the balance sheet. Here’s an example.

    Example: GIII

    Below is the balance sheet of GIII. Based on the report, the NCAV per share of GIII can be calculated in this way:

    NCAV per share = (1174 – 1032 – 0) ÷ 48.359 = $2.936

    Quarterly Balance Sheet of GIII
    Quarterly Balance Sheet of GIII


    It should be noted that the values of inventories and account receivables are taken at 100% face value in the formula. However, in reality, inventories are not guaranteed to be sold at full price especially for goods with short life cycles such as fashion products or products that have special usage and thus small market such as heavy equipment used in steel production or mining. To the same token, companies can’t assume all customers will pay their debts. It’s possible part of account receivable could turn out to be bad debts. Therefore, Graham suggested applying discounts of 2/3 on the valuation estimate.

    Net-Net Working Capital (NNWC) formula

    Alternatively, Graham developed the NNWC model to apply specific discounts on those items:

    NNWC = (Cash + Short Term Investment + 0.75 × Account Receivable + 0.5 × Inventroeis – Total Liability) ÷ Outstanding Common Shares

    Updating the valuation of GIII, we get a new valuation estimate:

    NNWC per share = (253 + 0.75 × 277 + 0.5 × 575 – 1032) / 48.359 = $ -5.8

    Comparing the results of the two formulas, we can say that the NNWC formula could significantly affects companies that have big inventories and account receivables. For this reason, it is more difficult for companies to pass the undervalued standard of NNWC than NCAV.

    In the case of GIII, due to the pandemic, it is not surprisingly that the apparel manufacuring company suffers from high inventories (nearly $6 hundred million).

    Net-Net Strategy Still Works

    Academic research and practice of Net-Net strategy has shown positive results. For instance, an article published on NASDAQ reviewed historical studies on the Net-Net strategy and found that “regardless of the differences in methodology and the markets where these studies were conducted, stocks meeting Graham’s net current asset value criterion outperformed a broad market average – and notably. Not only did the strategy return continued superior performance, it also had fewer losing years.” Countering those who claim “value stock is dead,” a more recent test of the Net-Net strategy also generated impressive returns.

    With that said, Net-Net strategy is more of a short-term investing strategy. Since the strategy focuses on the immediate balance sheet condition, the use of modern data technology helps investors quickly detect companies whose prices are below Net-Net values and grab the opportunities. Moreover, the Net-Net straegy does not take into account quality of management and the probability of long-term worsening of balance sheet.

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