Thursday, 10 October 2013

Net Net Working Capital (Value Investing)

Net Net Working Capital = Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities
“Net Net Working Capital” (NNWC) is one of the first stock valuation screening methods to be defined in the value investing world.  Benjamin Graham also referred to this as Net-Current-Asset Value (NCAV).
The Net Net Working Capital formula may help identify undervalued stocks.  Benjamin Graham actually used the term “Net Working Capital” but current value investors and Graham followers use the terms “net nets” or “Net Net Working Capital” interchangeably.
One value investing strategy of Graham was to purchase stocks that were trading at less than two-thirds of the Net-Current-Asset Value per Share (i.e. less than two-thirds of the Net Net Working Capital Value per Share).  This type of value investing strategy could be thought of as a “liquidation value investing strategy”.  In other words, Graham is proposing that the stock is so cheap that even under a situation where the business was wound down, that the investor would have a such a suitable margin of safety that a return could still be earned.  Of course, Graham is not counting on a liquidation since there are costs associated with that action.  Rather, Graham is satisfied that he is paying nothing for the fixed assets of the business nor is he paying anything for any potential earnings.
According to Graham, The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.* This would mean that the buyer would pay nothing at all for the fixed assets—buildings, machinery, etc., or any good-will items that might exist.  Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.”  (Source:  The Intelligent Investor by Benjamin Graham).
Of course, stocks that are trading below their NNWC may be trading at such low multiples for various reasons (e.g. pending bankruptcy, misstated financial statements, or a host of reasons why investors may be shunning a particular stock).  Regardless, we present the Net Net Working Capital formula and provide further discussion.

Net Net Working Capital = Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities
Once the NNWC is determined, this amount divided by the number of shares outstanding will provide the NNWC per share.  NNWC per share that is less than the current share price may be an indication of an undervalued stock or a deep value stock.  Graham advocated buying a basket of stocks whose prices traded significantly below NNWC per share (or Net Current Asset Value per Share – NCAV per Share).
The NNWC formula considers that not all balance sheet amounts may reflect current reality.  A 25% discount is applied to accounts receivable as these amounts may not actually be collectible.  In addition, a 50% discount to inventory is applied given that it may be stale or obsolete.  Of course, this is a first screen and potential investors should consider whether further discounts would be prudent.
The estimation or calculation of intrinsic value is as much art as science.  Any investor can run a mathematical screen to identify stocks trading at various metrics that could indicate potential value.  However, it must take keen business sense and deep curiosity to ask why a stock may be trading at the level it is, whether there actually is business value and how much, and what potential catalysts could emerge to unlock value.  The Net Net Working Capital formula is one more value investing tool.
Net Net Working Capital Formula – Further Analysis and Discussion:
Net Net Working Capital is a subset of Graham’s Net Working Capital is a subset of Net Working Capital (also known as Working Capital).
1) Net Working Capital = Current Assets – Current Liabilities
2) Graham’s Net Working Capital = Current Assets – Total Liabilities
3) Net Net Working Capital = Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities
Note that the results of each formula are presented in a decreasing order.  That is to say Net Net Working Capital will provide the lowest and hence, most conservative, value.  In other words, all else being equal, of the three formulas above, a stock trading below Net Net Working Capital provides the investor with the largest margin of safety.
Value investing is about buying a stock at a sufficient discount to intrinsic value.  Graham’s “Net Working Capital” or the “Net Net Working Capital” formulas can be used as preliminary screens to identify potentially undervalued stocks or deep value stocks.

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