Excerpts from Security Analysis on Wall Street by Jeffrey C. Hooke (Pages 384 to 385)

Liquidations

First you must determine if the company can remain as a going concern. If not, then a publicly held company is viewed as a liquidation candidate. It has poor prospects as an operating business and shows a history of losses. Investors appraise the business not as a going concern, but rather as a collection of assets better off in the hands of others.

In performing a liquidation analysis, you examine the worth of each asset category in a quick sell-off, aggregate these liquidation values, and subtract from this sum the estimated cost of closing the business and paying off its liabilities. If this calculation provides a positive number, such as $10 per share, you have established a ceiling purchase price. From this $10 must then be subtracted your time-adjusted rate of return requirement.

Unless the business has substantial intangible assets such as well-respected brand-names, exclusive patents or quasi-monopoly operating rights, the first “back of the envelope” evaluation focuses on historical balance sheet data. For each balance sheet item, you determine an estimated range of “liquidated value” percentages, which are based on experiences for similar businesses. Later on, after further study, these percentages are adjusted to include the new information. Consider the hypothetical case of Siegel Corporation, a troubled manufacturer of construction materials, as presented in Exhibit 23-15

Siegel Corporation—Summary Liquidation Analysis (in millions except per share).

Historical
Book Value / Estimated Liquidation Percentages / Estimated Liquidation
Values
Assets
Cash / $ 10 / 100% / $ 10
Accounts receivable / 40 / 70 / 28
Inventory / 40 / 50 / 20
Totals / 90 / 58
Plant & Equipment / $100 / 40 / 40
Goodwill / 20 / 0 / 0
$210 / $98
Liabilities and Stockholders’ Equity
Short-term debt / $ 15 / 100 / $ (15)
Other current liabilities / 25 / 100 / (25)
Total / 40 / (40)
Stockholders’ / 170 / Costs of shutdown / (8)
$210 / Net Outflows / $(48)
Net Liquidation
Value (98 – 48) = 50) / $ 50
Shares Outstanding / Divided 5
Value per share / $ 10

The $50 million liquidation value is far below Siegel’s stockholders’ equity of $170 million. This significant discount to book value is characteristic of most liquidation analysis and emphasizes an important point: Firms realize a better stock price when they are viewed as going concerns, whereby their respective values are based on future earnings power rather than on tangible asset compositions. To prove this assertion, one need only look at the November 1997 pricing for the Dow Jones Industrials, which were then trading at 5x historical book value.

Unless an analyst works for a firm that is considering a takeover of Siegel Corp., there is no way for him to unlock the liquidation value. Thus, his rate of return requirement must reflect not only the uncertainty of his liquidation estimates but also (1) Siegel’s burn rate and (2) the likelihood of its acquisition by a third party interested in unlocking those values. Assuming a 30% IRR requirement and a two-year holding period, the $10 liquidation value translates into a $6 investment price (i.e., $10/($1.30)^2

Security Analysis, Third Edition 1951 by Graham and Dodd.

Chapter 38 pages 475 - 491: The Asset-Value in CommonStock Valuation

Note that this chapter was written before 1951. The principles hold but the examples may seem strange such as companies trading at 3 – 4 x earnings.

Earning-Power Value and Liquidating Value.

In the legal approach to valuation and enterprise isusually considered to be worth at least as much as the net amount that could be realized by its sale or liquidation. The liquidating value is minimum value because, if worst comes to worst, a concern can be sold or liquidated. In other words, no business is worth less to its owners than they could realize from it by sale. For if a business could not earn enough to support the liquidating value, ordinary prudence would suggest that it be wound up or disposed of and that the sale value or liquidating value be turned over to its owners.

On this point, the legal approach to valuation appears to diverge widely from the stock-market or practical approach. Stock prices do not reflect any presumption that liquidating value is minimum value. The reasoning of the market—i.e., of investors and speculators generally—is that liquidating value is of no practical importance in the typicalcase. For the typical company—whether prosperous or not—is not going to be liquidated. True, the liquidating value does sometimes become important when a non-prosperous company sells out or merges. But these occurrences are comparatively rare, and they are so unpredictable that they cannot justify paying more for a stock than it would be worth solely on a going concern basis without regard to its assets.

The ignoring of realizable asset value by the stock market is perhaps the most clear-cut and striking element of difference between its approach to value and that of private business. Let us call this the “Wall Street approach” and the “Main Street approach.” On Main Street the idea that a business is worth much less than you could auction it off for would seem preposterous, but in Wall Street, people think of themselves as owning not a part of a business but shares of stock in a business. These shares may be valued, bought and sold on a basis that bears little relationship to a normal appraisal of the business entity on which they have their ownership claim.

Net-Current-Asset Value as Liquidating Value

To discuss this phenomenon more concretely, let us shift our attention from “liquidating value” to “current-asset value.” The analyst cannot calculate accurately the liquidating value of a given company, since it is ordinarily impossible to estimate what could actually be realized for its fixed assets and what the expenses of liquidation would be. But we do know as a practical matter that most companies could be disposed of for not less than the net working capital if the latter is conservatively stated. As a general rule, at least enough can be realized for the plant account and the miscellaneous assets to offset any shrinkage sustained in the process of turning the current assets into cash. (This rule would apply in nearly all cases to a negotiated sale of the business to some reasonably interested buyer.) The working-capital value behind a common stock can be readily computed. Consequently, by using this figure as the equivalent of “minimum liquidating value,” we can discuss with some degree of confidence the actual relationship between the market price of a stock and the realizable value of the business.

The historical development of this relationship has been interesting. Before the 1920’s, common stocks selling under current-asset value were practically unknown. During the “new-era” market, when prime emphasis was placed on prospects to the exclusion of other factors, a few issues in depressed industries sold below their working capital. In the great depression of the early 1930’s this phenomenon became widespread. Our computations show that about 40% of all industrial companies on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets. Many issues actually sold for less than their net cash assets alone. Writing about this situation in 1932, we stated that the market prices as a whole seem to indicate that American business was “worth more dead than alive.” It seemed evident that the market had carried its pessimism much too far—to compensate no doubt for its reckless optimism of the 1920’s.

In the appraisal of most (nonutility) common stocks their asset value is of minor importance. This is true whether we are considering the implied standards of the stock market itself, or accepted techniques of analysis or legal theories of valuation as they have developed in recent years. In the day-to-day prices of the stock markets, it is generally impossible to identify any influence exerted by asset values. This point may be illustrated by Table 115, which shows quite characteristic relationships between year-end price and year-end asset value in 1949 for a group of common stocks of steel companies.

Table 115. Selected Data on Steel-Company Stocks (per share)

Closing Price, Dec. 31, 1949 / Book value
(S&P) / 1949 earnings / 1949 dividend (including extras) / Year-end ratio of price to earnings
Armco / 28.66 / 45.51 / 7.68 / 2.50 / 3.7x
Bethlehem / 32 / 69.88 / 9.68 / 2.40 / 3.3x
Inland / 39 / 38.10 / 5.11 / 3.00 / 7.6x
Jones & Laughlin / 29.5 / 90.88 / 7.5 / 2.60 / 3.9x
National / 92.5 / 112.21 / 16.02 / 5.50 / 5.8x
Republic / 23.75 / 58.18 / 7.54 / 3.00 / 3.1x
U.S. Steel / 26.62 / 64.15 / 5.39 / 2.25 / 4.9x
Wheeling / 47.13 / 144.09 / 10.68 / 4.00 / 4.4x
Youngstown / 75.5 / 144.89 / 18.97 / 6.00 / 4.0x

The possession of tangible assets does not appear to have been of any help to the companies in this list. On the contrary, Inland Steel, with the least assets per dollar of market price, sold at the highest multiplier of 1949 earnings, while Jones & Laughlin, with the most assets per dollar of price, sold at a somewhat lower multiplier of earnings than the group as a whole.

There are several classes of exceptions to the general stock-market rule that asset values are of negligible importance. The outstanding exception is the public-utility field. Here the actual property investment plays a significant role in determining the earnings permitted under rate regulation, and thus earning-power value tends to remain reasonable close to asset value. In the large sector of financial companies the asset value remains a prominent element in the valuation of a common-stock issue. In fact the appraisal process is likely to start with the asset value as a point of departure and to add a premium or to subtract a discount there-from to reflect the many other elements of valuation. This statement applies fairly generally to banks, insurance companies, and investment funds, but only slightly, if at all, to finance or credit companies.

In a less direct fashion the asset-value factor enters into market price in the case of companies with relatively small earnings and dividends and relatively large net current assets. While in such cases the market does not ordinarily pay close attention to the current-asset value of the shares, it is possible to trace some influence exerted by this factor. For example, it is comparatively rare for a stock to sell at less than, say, 40% of its indicated current-asset value, whereas no similar minimal relationship may be traced in the market between price and total-asset value including plant.

Common-stock analysis as it is generally practiced in Wall Street and reflected in the published studies of individual issues adheres pretty closely to the canons of value apparently set up by the stock market itself. Thus we do not find any tendency in such studies to emphasize asset value generally, although the figure is often stated, and in some cases attention is called to the fact that the asset value is many times the market price. (The converse situation is practically never referred to.) It is only in the past twenty years that analysts have had to deal with a large number of stocks selling below their current-asset value. Their attitude toward this phenomenon has been tentative and uncertain. The fact that a stock is selling well below its liquidating value is usually pointed to as “interesting” but with the added caution that it cannot be relied upon as a guide to successful investment.

In legal valuations ruling principles have changed substantially in the last generation. In earlier years the point of departure was always the tangible asset value-subject to modifications according to certain formulas which generally sought to determine how much should be added to the tangible investment to reflect the good-will. Today the standard legal valuation is what a willing buyer would pay a willing seller, if both were conversant with the facts and intelligent, and if neither was under any pressure to trade. (This is a private market transaction). It is assumed that the price agreed upon by this buyer and seller would be found mainly by capitalizing expected future earning power. Thus legal value has tended to identify itself with ordinary investment value as found by “experts.” This affords little recognition of the asset-value factor. However, in statutory appraisals of the shares of dissenting stockholders we frequently see the asset value used as a separate factor, to which either a certain percentage weight5 or some less definite notice accorded. Furthermore, there is a fairly well defined tendency to consider the liquidating value—for which current-asset value may be taken as a rough guide—as the lowest fair value of an enterprise for purposes of reorganization, taxation, and the appraisal of dissenting shares.

In the succeeding pages we shall subject the asset-value elements to some independent scrutiny. First let us ask ourselves whether the almost universal attitude of ignoring asset value in the general or ordinary case is entirely sound. Second, let us consider the various kinds of special cases in which asset values admittedly play a more or less important part. Thirdly, we shall point out the little understood but vitally important ways in which asset value enters into the measurement of the success of an enterprise, thence into the testing of the accomplishment and competence of management, and finally into the area of stockholder-management relationships.

The General Relationship between Asset Value and Investment Value.

We started this chapter by stating flatly that asset values are ordinarily of minor importance in appraising the common stocks. Why is this so? The general answer is that a stockholder depends upon dividends for ultimate value; that dividends in turn are derived from earnings; but that earnings in their turn are not derived from earnings; but that earnings in their turn are not derived in any clear-cut or ascertainable way from the asset values. If 100 stocks are taken at random, no convincing relationship could be traced between their earnings and the equity per share. This viewpoint is thoroughly entrenched and undoubtedly too well grounded to be challenged as fallacious. But certain questions remain unanswered.

Asset Value in Appraisal of Private Business

…But we are fairly sure that the typical private business is valued first by relation to the net worth as shown in its balance sheet. If the earning power is large, an increment for good-will is clearly present. If the earning power is large, an increment for goodwill is clearly present. If the earning power is quite low or nonexistent, the fixed assets may be marked down by the valuer to their realizable values, just as inventories and receivables are regularly so market down in the annual audit. Why should net assets, either per books or as modified, be the controlling or at least the starting factor in the valuation of a private business, and be left almost entirely out of the reckoning when publicly traded shares are in question?

Surely the mere presence of a quoted market should not properly change the basis of value. In logic, marketability is merely an added factor of value. A given stock under given circumstances should always be worth some percentage more if it has a quoted market than if it has not. But we must emphasize that, in practice, the conversion from a close corporation with unquoted shares to one with listed or over-the-counter securities is not a matter of simply to one with listed or over-the-counter securities is not a matter of simply assign a new element of value, but rather of changing the psychological attitude of the owners of its shares, and consequently changing also the criteria of value applied to it in the market lowest value their owners would set upon them—and be willing to sell them for—if they had no published quotations. The chief reason for this fact, undoubtedly, is that as long as a stock has no market its asset value retains importance in the minds of the owners; but soon after a market has been created, the asset value seems to lose all significance.

Stated Asset Value Unreliable.

In partial explanation of this seeming irrationality of finance we may mention three plausible reasons why asset values have been entitled to less weight in the case of publicly owned stocks than in private businesses. The first is that, historically, the stated asset value of active common stocks was often unreliable—or, more bluntly stated, falsified, the plant-account total included large but unrevealed amounts for intangibles or “water.” Since the figures supplied were meaningless, it was natural and sensible to ignore them.

Asset Value Dependent on Earning Power.

The second reason is that the typical publicly owned business has been of the kind in which the true worth of the physical assets is largely bound up with their earning power. The realizable value of the plant or machinery, in the absence of profitable operation, may be extremely low. When there is substantial debt and preferred stock outstanding, these low values plus the working capital would leave no residue whatever for the common stock. In the smaller private businesses the fixed assets may be more readily disposed of, and in a fair proportion of such concerns, the working capital makes up most of the book equity.

Unavailability of the Assets.

The third reason is that ownership of or in a private undertaking is generally identified with control of that business. (Minority shareholdings not part of a cohesive management or family group are the exception rather than the rule.) Thus the owners of the stock or partnership shares consider themselves as having direct access to the assets. Consequently, what the net assets are wor4th, plus possible good-will is more or less the same thing as what the business is possibly worth. The typical outside stockholder of a listed company has no practical access to his share of the net assets. The theoretical access which he has by moving jointly with his fellow stockholders appears to him to be an empty privilege and scarcely enters into his calculations.