Intelligent Investor's Notes: Graham Net Net & Negative Enterprise Value

NCAV = Current Asset - Total Liabilities- Preferred Stock
Current Asset are already cash or convertible into cash within a relatively short period of time.
Stock price sold higher than book value was driven by a company’s earning power and dividend payments.
Stock price is less than the per NCAV were primally driven down by poor earnings.
Graham isn’t interested in the total assets of a company. He is only interested in the most liquid assets on the balance sheet.
“To be as concrete as possible, let us suggest that an issue is not a true ‘bargain’ unless the indicated value is at least 50 percent more than the price.”
“…if a common stock can be bought at no more than two-thirds of the working-capital alone—disregarding all other assets—and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money’s worth.”

The lowest form of valuation - ignores everything & just focuses on tangible assets.
NNWC = Cash and short-term investments + (0.75 x accounts receivable) + (0.5 x inventory)
- total liabilities
Investor have to weeding out the bad one and look for a business that is stable so that operating losses don’t eat away the existing cash and other components of Net Net Working Capital.
Is Net Net valuation infallible?

AR in Construction - can very well vanish into the thin air, or turned to be payable. (dispute, abbitration, court case)
Inventories in Fashion or Technology - it can end up worthless
Cash - may end up in other people pockets or burned away due to improper allocation of resources / poor business with persistent loss

Enterprise Value = Market Capitalization + Total Debt - Excess Cash
Excess Cash = Total Cash - MAX(0,Current Liabilities-Current Assets)
If the excess cash in cash and marketable securities exceed the cumulated market values of debt and equity, it gives you a negative enterprise value.
An easy arbitrage opportunity, where you can buy all of the debt and equity in a firm and use its cash balance to cover your investment costs and keep the difference (in theory......)

Business trade under NNWC facing some serious pressure and trouble (business sucks) and that threaten to put them in bankruptcy -- that's why business operations are completly ignored.
There is a lot of volatility and you need to buy micro or small caps - it is not for faint hearted.
Two possibles reasons why Net Net may fail:-

Changing intrinsic value - based on development of business e.g. loss money & reduce it working capital
Market behaviour - stock price not necessary follow to the value that analyst place on it.

“Reasonably satisfactory” earnings record and prospects: Companies that are losing money or have an erratic earnings history are likely to see their intrinsic value decline, making them less undervalued or potentially overvalued.
“Sound financial condition”: As a test for financial strength, Graham suggests looking for companies with total stockholder’s equity (common and preferred equity) greater than the total of current liabilities and long-term debt.
Positive operating cash flow for T4Q: To prevent companies liquidate assets to meet its obligations
Prevent Perennial net nets: companies that are stuck trading below their NCAV.

“…stocks selling below working capital and showing a fair record of earnings and dividends are likely to be ‘bargain’ issues and are likely to turn out to be unusually satisfactory purchases.” [Graham used the terms working capital and net current assets interchangeably.] To offset the potential of investing in individual stocks that turn out to be unprofitable, Graham suggested holding at least 30 stocks at a time.

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Intelligent Investor's Notes