Value of a Business to a Private Owner Test
The private-owner test would ordinarily start with the net worth as shown in the balance sheet.
How to search for a bargain opportunity?
1. Using the net worth as the starting point
The question to ask is: Is the indicated earnings power sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole?
If the answer is definitely yes, an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.
2. Using the working capital as the starting point
If instead of using all the net worth as a starting point, the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.
For it is something of an axiom or is self evident, that a business is worth to any private owner AT LEAST the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.
If a common stock can be bought at no more than two-thirds of the working capital value alone - disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.
An example of how to find a bargain common stock:
[Peculiarly, in 1947, many such opportunities present themselves in ordinary markets. Benjamin Graham]
National Department Stores as of January 31, 1948, the close of its fiscal year.
The price of the stock was 16 1/2.
The working capital was no less than $26.60 per share.
The total asset value was $33.30.
Deducting contingency reserves - mainly to mark down the inventory to a "LIFO" (last in first out) basis, these figures would be reduced by $2.20 per share.
The company had earned $4.12 per share in the year just closed. The seven-year average was $3.43; the twelve-year average was $2.29. (Growing earnings)
The year's dividend had been $1.50. (Paying dividends)
Compared with a decade before,
- the working-capital value had risen from $7.40 per share to $26.60,
- the sales had doubled and (Increasing sales)
- the net after taxes had risen from $654,000 to $3,224,000. (Increasing profits)
Thus, we had a business
- selling for $13 million,
- with $25 million of assets, mostly current. (Price < Net Assets)
- Its sales were $88 million. A fair estimate of average future earnings might be $2 million. (earnings record and prospects are reasonably satisfactory or Not gruesome)
The average earnings prior to 1941 had been unimpressive, and the company was regarded as a "marginal" one in its field - that is, it could earn a reasonably good return only under favourable business conditions. (Qualitative assessment)
In the past eight years, however, it has improved both in financial strength and in the quality of its management. (Qualitative assessment - earnings record and prospects are reasonably satisfactory or improving quality of business and management)
Let us grant that Wall Street would still consider the company as belonging in the second rank of department-store enterprises. (Investor sentiment/Market sentiment/Neglected by market)
Even after proper allowance is made for such an unfavourable factor, we may still conclude that on the basis of the figures the stock is intrinsically worth well above its market price. (Worse case scenario, still Value > Price)
Conclusion: At 16 1/2, the conclusion in the case of National Department Stores remains, whether we apply the appraisal test or the test of value to a private owner. (Undervalued / A bargain)
The private-owner test would ordinarily start with the net worth as shown in the balance sheet.
How to search for a bargain opportunity?
1. Using the net worth as the starting point
The question to ask is: Is the indicated earnings power sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole?
If the answer is definitely yes, an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.
2. Using the working capital as the starting point
If instead of using all the net worth as a starting point, the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.
For it is something of an axiom or is self evident, that a business is worth to any private owner AT LEAST the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.
If a common stock can be bought at no more than two-thirds of the working capital value alone - disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.
An example of how to find a bargain common stock:
[Peculiarly, in 1947, many such opportunities present themselves in ordinary markets. Benjamin Graham]
National Department Stores as of January 31, 1948, the close of its fiscal year.
The price of the stock was 16 1/2.
The working capital was no less than $26.60 per share.
The total asset value was $33.30.
Deducting contingency reserves - mainly to mark down the inventory to a "LIFO" (last in first out) basis, these figures would be reduced by $2.20 per share.
The company had earned $4.12 per share in the year just closed. The seven-year average was $3.43; the twelve-year average was $2.29. (Growing earnings)
The year's dividend had been $1.50. (Paying dividends)
Compared with a decade before,
- the working-capital value had risen from $7.40 per share to $26.60,
- the sales had doubled and (Increasing sales)
- the net after taxes had risen from $654,000 to $3,224,000. (Increasing profits)
Thus, we had a business
- selling for $13 million,
- with $25 million of assets, mostly current. (Price < Net Assets)
- Its sales were $88 million. A fair estimate of average future earnings might be $2 million. (earnings record and prospects are reasonably satisfactory or Not gruesome)
The average earnings prior to 1941 had been unimpressive, and the company was regarded as a "marginal" one in its field - that is, it could earn a reasonably good return only under favourable business conditions. (Qualitative assessment)
In the past eight years, however, it has improved both in financial strength and in the quality of its management. (Qualitative assessment - earnings record and prospects are reasonably satisfactory or improving quality of business and management)
Even after proper allowance is made for such an unfavourable factor, we may still conclude that on the basis of the figures the stock is intrinsically worth well above its market price. (Worse case scenario, still Value > Price)
Conclusion: At 16 1/2, the conclusion in the case of National Department Stores remains, whether we apply the appraisal test or the test of value to a private owner. (Undervalued / A bargain)
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