How to Invest Like a Deep Value Financier
Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Deep value investors are a special breed.
Like their conventional value cousins, deep value investors focus on buying stocks at material discounts to their intrinsic value. However, deep value investors will often look into the strangest places to find opportunities; distressed assets, penny stocks, spinoffs, etc.
How can you emulate their strategies? Let’s take a look at one tool in the deep value investor’s arsenal: liquidation value.
Liquidation value has several advantages over other valuation techniques. 1) It’s the most conservative estimate of a company’s intrinsic worth. 2) Liquidation value is fairly simple to calculate. It is far easier to value balance sheet items such as cash, real estate and inventories than it is to estimate the intangible value of a business such as its going concern value or goodwill.
Calculating Liquidation Value
Calculating the liquidation value of a firm is a straight forward formula:
Liquidation Value of Firm = Liquidation Value of Assets - Liabilities
The main goal of the investor is to determine the value of the company’s assets if the business was liquidated today.
- Cash and Cash Equivalents – Cash should be valued at 100 cents on the dollar. Cash equivalents should be marked at face value less transaction costs.
- Account Receivables – Receivables should be valued at 75% to 90% of book value.
- Inventories – Inventories are difficult to evaluate and depends on the business being assessed. For example, a grocery store may be able to liquidate its inventory cheaply and quickly whereas a warehouse full of electronics may be worthless. Generally inventories are valued between 25% and 75% of book value.
- Long Term Assets - A company’s fixed assets are also difficult to assess. Investors must ask if the assets can generate cashflow either for its current use or alternative uses. Grade A office space can be liquidated easily whereas as lumber mill would be less valuable. Fixed assets can be valued anywhere from 0% to 90% of book value.
Investors must conduct a full due diligence to determine why the firm is trading at such a steep discount. Common red-flags include:
Negative Cashflow: Common stocks in this category usually have a negative trend in earnings. There’s the possibility that if losses continue, investor capital will be squandered and the intrinsic value of the firm will be less than the price paid.
Hidden Liabilities: Often a stock will show up on a value screen because of a hidden liability not reflected on the company’s balance sheet. For example, perhaps the company faces a lawsuit. Often, this information can be found by studying the footnotes in quarterly reports.
No Catalyst: Don’t count on liquidation just because it maximizes shareholder value. Management will often be reluctant to liquidate a firm. This is why it’s important to identify a catalyst that will keep management actions in line with shareholder interests such as an activist investor or large insider ownership.
To further illustrate the deep value concept, I created a screen of companies trading below or near their liquidation value with market capitalizations over $200 million and excluded financial service firms. Of course, this isn’t a list of buy recommendations but a place to begin further research. Here are the results:
Foolish Bottom Line
Stocks trading below or near their liquidation value represent attractive investment opportunities. First, investors have limited downside risk. In the event the business cannot return to profitability, management and shareholders will usually chose to partially or completely liquidate the company resulting in the return of capital. Second, stocks in this category may have large upside potential. In the best case scenario, the business returns to profitability as a result of improving industry conditions or changes in the company’s operations. Share prices can appreciate remarkably if the stock is once again valued as a going concern.
RobertBaillieul has no positions in the stocks mentioned above. The Motley Fool owns shares of Power-One and is short RadioShack. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!