Monday, April 19, 2010

Net-Nets: Beyond Liquidation

Companies trading at discounts to their net current assets are often valued by estimating their liquidation values. For many years, this may have made sense, as only companies in extremely terrible shape would ever trade at such levels. Since the market crash of 2008-2009, however, even companies with decent prospects of profitability have traded at such abysmal levels. As a result, it would be imprudent to value net-nets based only on their estimated liquidation values; instead, for the majority of cases, effort should also be exerted in valuing the company as a going-concern.

When a stock's estimated liquidation value is compared to its share price, the investor can get a decent idea of the stock's downside risks. But the upside in a stock is not limited to its liquidation value; assuming this to be true could result in an investor selling a stock for far below its intrinsic value.

Consider H Paulin (PAP), a manufacturer and distributor of automotive hardware components. The stock has doubled from its lows in 2009, and yet it remains an attractive purchase. To place a sell value on this stock that is equal to its estimated liquidation value would appear to be a little too conservative, even for the strictest of value investors. The company trades for $28 million, but earned $2.4 million in 2009 under very poor industry conditions.

Recall that this is a company that operates in two business lines, one of which is doing well while the other is faring poorly. By ceasing to invest in the poorly performing business, while increasing investment to the business that is growing profits and market share, the company is positioning itself for continued success. Indeed, based on a number of operating metrics, the company appears poised to add value for shareholders by continuing to grow its distribution business. As such, placing an upper-bound on this company's price that reflects only its estimated liquidation value could result in underestimating this company's actual worth.

Various research (one example here) suggests that buying a portfolio of stocks trading at discounts to their net current assets, and selling them when market values and net current assets converge, will beat the market. To value investors, this is old news. But it is likely possible to even outperform such a portfolio by not forcing stock sales in cases where a company's intrinsic value clearly exceeds its estimated liquidation value.

Disclosure: Author has a long position in shares of PAP.A


T. said...

Thanks for bringing this company to my attention!

My current estimates have NCAV at $14.60 and liquidation value at $6.05.. is that within your valuation of its intrinsic value?

Saj Karsan said...

Hi T,

Generally I don't like to get into valuations on this site. Having said that, your numbers are perfectly credible.

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