For a going concern, three asset valuation approaches are recognized:
- Net-net working capital
- Book value
- Reproduction cost method
Net-net working capital
The most conservative form of value investing examines solely current assets, subtracts all liabilities, and estimates the difference as the company’s value.
Graham made this famous as the net-net working capital figure.
If the target is selling for less than that difference, a sizable margin of safety exists.
It is somewhat impractical, however, for few companies today operate using current assets that are greater than total liabilities.
Such results are as rare as hen’s teeth today.
Book value
If a company can be bought for a per-share price equal to less than the difference between its reported total assets and reported total liabilities, it probably furnishes a comfortable margin of safety as well.
While such companies sometimes exist in contemporary corporate America, they too are not common.
Also, value investing inclines some scepticism towards reported figures, justifying consideration of the third method of asset valuation called the reproduction cost method.
Reproduction cost method
In the reproduction cost method of balance sheet valuation, the concept is to value a going concern on the basis of what it would take a new entrant to its business to build it from scratch at current costs or replacement value.
All a target’s resources and claims against it are separately assessed and netted out. The cash, securities, receivables, and inventory probably can be taken at face value, as can prepaid expenses.
- Investigation is required to ensure that receivables have been adequately reserved through the allowance for bad debt accounts.
- Further investigation is required to ensure that inventory accounting is neither overstated (due to aging that suggests they are non-saleable for example) nor understated (due to inflation in sales prices compared to historical records concerning the cost of those goods held for sale).
- Fixed assets should be adjusted to reflect current market conditions, compared to the historical prices (net of depreciation) at which they are carried on the books.
- Accounting goodwill remains an asset class warranting little valuation accretion.
Also read:
1.Balance Sheet Value: Assets at Work
2.Reliability of financial data
3.Asset valuation approach in liquidation
4.Asset valuation approaches in active companies
5.Valuing Hidden assets
6.Subtracting liabilities in asset valuation
7.Balance Sheet Value: Summary
