Triggered upon comments from couple of fellow bloggers, Musicwhiz, GMGH, Richard and Jason in the previous post, I went to read further on Greenwald's take on reconstructing the book value using a Reproduction Cost Basis methodology which I will talk in detail in this part 2 series of valuing assets and how when combined with other earnings metrics such as EPV which he favored (which I will talk in part 3 of the sequel later) more than the DCF method, this could become a powerful valuation method.
This will be a rather long post because I will explain each balance sheet item but if you can stay till the end, you probably will think behind the reason for doing so and can help you in your future asset valuation. I certainly learnt a lot just by doing this.
The idea for this type of asset valuation is to figure out how much a competitor would have to spend in order to replicate the company's business. Unlike Graham's method where he discounted certain percentage of the assets value in his books, the reproduction cost method requires you to go through each line item of the balance sheet thoroughly to see if they require any adjustment.
This may require you to understand some of the accounting treatment and business moats of the company, but we'll see where it takes us.
Balance Sheet (Assets)
1.) Cash & Cash Equivalent
These are taken at face value, assuming you are confident that the cash is really available in the books. So no adjustment is required here.
2.) Marketable securities or investment
These assets are marked to their market value so again no adjustment is required here. This is the very same reason why book value for trading companies and banks are more relevant than say biochemical companies.
3.) Accounts Receivable
You need to add a doubtful reserve premium to this category because a competitor will not have the same competency of being able to perform the same level as the original company.
Do also look out on whether the Accounts Receivable have bad debt provision already accounted for when they are reported in the books. Most accounting treatment requires companies to report net of Accounts Receivables (after less off bad debt provision) in their books but for those who has reported separately, do discount the adjustment for the provision. Depending on the company's risk profile, the provision may look like this.
Overdue Ageing Outstanding
Current - 0%
1-30 days - 2%
31-60 days - 5%
61-90 days - 10%
>90 days - 50%
Here, you probably need look at whether you are analyzing US or other Asian companies.
Under IFRS, the LIFO (Last-in-First-out) method for accounting for inventory costs is not allowed, so you can be safe that every companies are using similar accounting treatment. In this case, no adjustment is required.
But if you are analyzing US companies under the US Gaap, some companies may either use LIFO or FIFO method for accounting their inventory. In this regard, you may need to adjust by adding back if the company is restating its accounting treatment from LIFO to FIFO and vice versa.
Do take note also that under IFRS, inventory's write down can be reversed in future periods while US Gaap prohibits that writeback. In any case, do account for all these matters when you are adjusting for reproduction cost.
5.) PPE (Property, Plant and Equipment)
This is one of the thing I have highlighted in my previous post.
Items on the PPE will need to be depreciated over time. And depending on the types of depreciation method the company has chosen, you may be required to adjust back when restating them to a different depreciation method of accounting. E.g: From Double Accelerating to Straight Line method.
Freehold and Leasehold land would also need to be restated to their latest appraisal market price. This means that you would most likely need to add back since they are recorded at historical costs on the PPE.
Machinery and Equipment is a little tricky as they become obsolete over time. However, if the equipment is specialized, they may have a special salvage value you can adjust for.
Goodwill is harder to estimate as they represent an intangible part of the company that may be most important to the company. Think Pfizer or Coca-Cola.
If you want to be conservative, you can take the value as it is on the books.
|Example of Reproduction Cost Asset|
Balance Sheet (Liabilities + Equities)
On the other side of the equation, we have the liabilities and equities portion to match replicate the assets.
Unlike normal book value computation where we subtract all the total liabilities, the reproduction cost method only require you to deduct certain liabilities such as spontaneous and circumstantial liabilities.
1.) Spontaneous liabilities
Spontaneous liabilities arise from the day to day working capital operations that are not required by the new business. Thus, this amount should be deducted from the reproduction value.
These can be tied to changes in the cost of goods or sales or accounts payable. For example, you can take 10% of cost of goods sold as those not needed by the new business.
2.) Circumstantial liabilities
As the name suggests, these are usually your liabilities circumstances depending on the business you are operating. For example, oil companies usually need to accrue for items such as oil spills or lawsuit and these type of liabilities do not add any value to generating assets, thus they are deducted.
3.) Cash not required to run the business
These are probably conservative cash figure that is deducted for not requiring to run the business. Usually, these are taken at around 1% of sales or cash amount.
Thus putting it all together, we get Reproduction Value at:
Adjusted Asset Value - Spontaneous liabilities - Circumstantial liabilities - Cash not required in business
You can see how this is more intensive than simply computing the book value, which is your NAV of the company you are tracking. As with all valuation method, this only takes into account the balance sheet value, and it probably need to be combined with other earnings metric to get a better overall valuation out there.
I will read up on some of the earnings valuation and share in part 3 series in time to come.
Thanks for reading and let me know your thoughts or comments.