This article on liquidation value was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by Frederic BISSON, edited by Broken Leg Investing.
Have you ever wondered what net net investing really is — or why it even works?
Made famous by legendary investor Benjamin Graham, net net investing is an ultra-conservative derivative of the stock valuation measurement known as liquidation value. In order to understand net net investing, one first must master liquidation value. This article provides you with the tools to do just that.
What Is Liquidation Value?
In his book Margin of Safety, Seth Klarman describes the meaning of a company’s liquidation value:
“The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment.
The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case assessment.”
As Klarman explains, liquidation value is essentially a worst-case assessment of a company’s intrinsic value. The idea here is that if a company is trading at less than the fair value of its net assets, it is extremely cheap. In other words, if a company is trading below its liquidation value, you can buy $1 of fair value for less than a dollar — a definitive way to buy the proverbial one dollar for fifty cents.
How Can You Apply the Liquidation Value Technique to Your Portfolio?
So, we might have fallen upon a gem here, right? How then should we actually apply the liquidation value technique when analyzing our investments?
Klarman has the answers:
“How should investors value assets in a liquidation analysis? An orderly liquidation over time is virtually certain to realize greater proceeds than a ‘fire sale,’ but time is not always available to a company in liquidation. When a business is in financial distress, a quick liquidation (a fire sale) may maximize the estate value. In a fire sale the value of inventory, depending on its nature, must be discounted steeply below carrying value. Receivables should probably be significantly discounted as well; the nature of the business, the identity of the customer, the amount owed, and whether or not the business is in any way ongoing all influence the ultimate realization from each receivable.”
What Klarman is saying here is that even though a company might have, say, $10 million of net assets, if it is forced to liquidate immediately — hold an ‘everything must go by tomorrow’ sale — then it is unlikely to receive the full fair value for its assets. Therefore, in order to determine a conservative liquidation value for a company, an investor must apply a discount to the company’s assets. Depending on what type of asset we are talking about (cash, inventories, receivables, property), different discounts should be applied in order to come to the company’s conservative liquidation value.
Where Does Net Net Investing Fit In?
So, how and where does net net investing fit in to this equation?
“In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate ‘net-net working capital’ as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year.) Net-net working capital is defined as net working capital minus all long-term liabilities. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all its liabilities, and still distribute proceeds in excess of the market price to investors.”
What this means for us is that net net investing is essentially a conservative approach to valuing a company using an already conservative technique — conservatism squared!
By assuming that all non-current assets are worthless — that you would receive NIL proceeds for the sale of all plant, property, and equipment — and applying steep discounts to current assets (apart from cash), an investor can be uber certain that their investment is a safe one with an extremely wide margin of safety.
Why Liquidation Value Just Makes Sense
Klarman completes his explanation of liquidation value by outlining why net net stocks also provide a clear catalyst:
“A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of underlying business value. Since value investors attempt to buy securities trading at a considerable discount from the value of a business's underlying assets, a liquidation is one way for investors to realize profits.
In addition to this, Klarman gives insight into why liquidation value is one of the few investment techniques that allows an investor to take a step back and remember the true meaning of a stock — an interest in the residual value of a company. Because the liquidation value and net net value focus directly on conservative measurements of the residual value, it brings us back to the true meaning of a stock. This understanding is one of the key characteristics that makes value investors truly value-seeking agents and is an important factor that we must remember in order to avoid slipping into the world of speculation.
“A liquidation is, in a sense, one of the few interfaces where the essence of the stock market is revealed. Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value.”
Klarman’s discussion of liquidation value provides us with some invaluable information on what it represents and how net net stocks — Benjamin Graham’s ultimate legacy — fit in to the equation. Liquidation value and net net investing provide logical and reasonable valuation techniques that also undoubtedly provide superior results. Ticking all of the boxes when it comes to value investing, it might be time to add net net stocks to your own portfolio.
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