Benjamin Graham Balance sheet research part 2

Lesson 9 Balance sheet part 2

Current ratio was the most important figure for Graham, at least when he published the book Security Analysis. It measures the liquidity and financial buffers. He thought this ratio was a reasonably accurate view of how much money could the owners get by liquidating the company. There are three possible reasons and their combinations why the market cap is less than the possible liquidating value:

1. The price that market offers is too low
2. The company´s directors have made serious mistakes.
3. The owners have a wrong attitude toward there assets.

You should remember that debts are real and the value of assets has to be disputed. You also have to remember that there is no possibility to define the exact liquidation value. This value needs to be compared with the price the market is offering. If your valuation is close to the market price, you can´t make any conclusions. The liquidation is in the best use in the situation where the company or some of it´s parts need to be liquidated. When the company has economic difficulties, the most productive parts of the company will be sold in fraction of their real value. When there is no such need, the liquidation values are much higher.

Graham had some simple ways of valuing the company assets:

• Cash, cash equivalents and marketable securities 100% of book value
• Receivables 75-90%, approximately 80% on average
• Inventories 50-75%, approximately 2/3 on average
• Others like real estate, intangible assets, and machinery, 1-50%, 15% on average

Of course, these are just approximate numbers, but it is better to be roughly right than completely wrong. Getting these numbers is more an art than science, except the cash and marketable securities part of valuation. These numbers also depend on the industry. The values of Inventories in the electronics industry become obsolete very fast compared to some other industries. And the inventories of the oil refineries can become more expensive, when oil prices increases. Machinery can also become worthless before all the depreciation has affected the assets in the assets. Intangible assets are hard to evaluate. Sometimes brands are much more valuable than what is their worth in the assets. You can find more exact information from the Graham´s book Security Analysis.

It is hard to find businesses that has undervalued assets in modern days. Most undervaluations come from intangible assets and their values are hard to define. Most often, companies with undervalued assets are found after a longer decline of the market prices. Graham thought you should sell the business, if the price in the markets has been a lot more lower than the liquidation value. In this case, you should ask yourself that is there any basis for keeping a company public or what should the directors do to correct the undervaluation. This can happen in three ways of a combination of them:

1. Improving the earnings power. It can happen through the improvement of the business conditions of the industry or changing the business into more productive by having new directors or trusting the current ones. It is most probable that new directors can achieve this change.
2. Through mergers or acquisitions. Directors of the other company might have better chances to change the business into better direction. There can also have some synergies by having a bigger business.
3. A public offer for the company or for its parts

Stock price that is well below the liquidation value of the company doesn´t automatically mean that you should buy the stock of an individual company. Instead of buying individuals stocks, Graham recommended to buy a diversified portfolio in which all the stocks are bought below liquidation values. It is clear that not all these kind of stocks are worth buying. They won´t fulfill all the expectations. As an investor, you are still pretty much in the safe place, because you shouldn´t be too worried about losing all your money. Graham also mentioned that you should still be sure to do your homework before buying. These companies should have shown so much earnings power in the past compared to market price today that they are not destroying the assets in the balance sheet. For some reason Graham had an image that these companies were the most successful, when the market prices weren´t in their highs or lows.

I hope you can find some time to think about Graham´s simple ways of valuing the company assets. Do you find them applicable in today´s world?

-TT