Desi Capitalist

Price is everything. Wrong price can put your portfolio in real trouble.
These days I’m working hard on valuation part of investing, i.e. how to value a business and come up with the right price for it’s stock.

“Price is what you pay, value is what you get.” ~ Warren Buffett

Graham used his net-net working capital method to evaluate businesses. Though these days such bargains are rare, I found one which is covered here.

Graham loved buying companies trading at a minimum 33% discount to their net-net working capital. If you read Graham’s writings, you’ll learn that the central theme of his investment philosophy was: ‘Margin of safety’. That is, you first protect yourself from losing money, once you limit the downside only then you think of possible upside. 33% figure here is the margin of safety.

If you look at a company’s balance sheet. For calculation purpose let us use 2011 financial results of Vijay Shanthi Builders. The report is here.
First we’ll calculate net working capital. Working capital is the amount of money left with a company to carry out its day to day operations after it has paid down all its short-term liabilities.
Now if you look at the report, you’ll discover four things:

1. Loans & funds, also termed as ‘secured & unsecured loans’, these are company’s long-term liabilities.
2. Next are fixed assets & investments. Fixed assets are buildings, machinery, equipments, land bank, vehicles, and other assets which help company in generating revenues.

Now Graham believed that one can not really value fixed assets because it is hard to determine their precise monetary value. I think this is justified; we can’t even determine the current value of the car we own, then how can we assess a companies assets?.
So we’ll leave fixed assets out of net-net working capital. Next comes investments the company has made. If the amount is not substantial, it’s better to ignore investments also.

3. Current assets: these are the assets which the company is about to use within one year. These represent things which can be readily converted into cash. It includes: inventory, cash in hand, cash in bank, loans & advances provided to suppliers or subsidiary companies.

4. Next comes current liabilities, these are payments the company has to make within one year. These include income tax payments, payments to suppliers, short-term borrowings of the company etc etc.

Now, in the first step we will calculate the net working capital. That is current assets minus current liabilities.
In our example:
Current Assets = 196.2 crore
Current Liabilities = 45.8 crore
Net working capital = Current Assets (196.2) – Current Liabilities (45.8) = 150.4 crore.

Now for net-net working capital we will also subtract the long-term liabilities from the net working capital.
Here long-term liabilities (loans & funds) are = 61.2 crore.
Hence net-net working capital = Net working capital (150.4) – Long-term liabilities (61.2) = 89.2 crore.

Now Graham wouldn’t pay more than 66% of this value i.e share price graham would pay = 66% x (net-net working capital) / Total no. of outstanding shares. Which is (66 x 89.2)/(100 x 2.619) = 22.44 Rs. per share.

What does net-net working capital mean?

As we saw above Graham used current assets, assets supposed to be consumed within one year, to pay for short-term as well as long-term liabilities. Once the company has paid everything it owes to the outsiders the leftover belongs to the owners i.e shareholders. In the left-overs also Graham paid only 66% of the short-term assets left. So, in case of liquidation, the fixed assets come for free.

Possible risks in this method:

Though it is rare to find such bargains, specially in the bull market. If found, the method holds true only when:
1. A company’s liabilities are very very low.
2. The company is sitting on heavy amount of cash.
3. Stock is beaten to very low price. But sometimes, the stock is down for reasons a common shareholder like us can not precisely decipher.
4. Company is accumulating inventories i.e. company is not able to sell finished products. In such a case, a closer look is very much needed. If a company’s sales growth is less than the inventory growth, there is trouble arising here.
5. Increased debtors: if the amount in ‘sundry debtors’ column is increasing since 2-3 years. Ring a cautionary bell, the company is not able to collect cash from the customers. Which indicates inefficient management.

After analyzing all the above factors, you may consider buying option. But beware, no single method of valuation is sufficient enough to arrive upon an investment decision.

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