Wednesday, June 22, 2011

Adjusting For Working Capital

Many investors, value and non-value alike, subscribe to the idea that a company is worth the sum of its future cash flows discounted to present value, minus net debt. (The main difference for value investors is that they will attach little, if any, credence to predicted growth rates in estimating future cash flows.) But circumstances can alter the "net debt" amount such that it can have a substantial bearing on the overall valuation.

As an example, consider Dorel (DII.B), a maker of juvenile products (e.g. car seats), bicycles, furniture and related products. Sales in the fourth quarter of 2010 were weaker than expected, resulting in a build-up of inventory as retail customers curbed ordering.

Three months later (to March 31st), inventory has come down in a few product lines, but is still high as the company expects a strong upcoming quarter in its bicycle division and does not want to run out of product. This inventory build is seasonal, as spring weather ushers in renewed consumer interest in this category.

Further affecting Dorel's working capital is the fact that many of the company's sales in the first quarter occurred in March, the final month of the quarter. This has the effect of bloating the company's receivables account, since many products have been delivered but have not yet been paid for.

The final effect on working capital is significant. To the casual observer, Dorel could appear to be a company relaxing sales terms to hit volume targets (hence the increase in A/R) with looming potential writedowns on the way (due to a high inventory balance). But for investors who trust this weathered management team, an adjustment to working capital is in order; this is because once the company's inventory and receivable balances return to normal, the company's net debt position should decrease.

In estimating the intrinsic values of companies under study, investors should be sure to adjust for balances that are out of step. Just as earnings should be "normalized", so too should balance sheet accounts that are out of whack. This will ensure a more accurate estimate of the business' long-term value.

Disclosure: Author has a long position in shares of DII.B

2 comments:

ND said...

Can you elaborate on your comment that the value of a company is the sum of its discounted cash flows minus net debt? I normally would say that the value is simply the sum of its discounted cash flows, period. Future cash flows should already have debt payments subtracted out, right?

Saj Karsan said...

Hi ND,

Yes you are correct, depending on whether you view cash flow as to the firm or to equity holders only. You are talking about the latter while I was referring to the former.

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