Don’t Ignore The Assets

January 14, 2008 by Joe Ponzio

There is a school of thought that says that the value of a business is entirely in its future cash flows and that all assets are tools that provide that cash flow. In essence, many people believe that assets and equity should be ignored entirely. Let’s look at it from a private owner perspective and follow it up later in the week with an examination of Buffett’s early partnership letters:

The Theory

The idea behind ignoring the assets is theoretically sound: The net assets produce the cash flows. Any reduction in net assets would reduce cash flows. Thus, the value of a business is comprised entirely of the future cash flows, plus excess capital that the business has.

The Question

So, what is considered excess capital? It is easy to say that additional cash above and beyond the company’s working capital needs is “excess” capital. What else might be considered excess capital?

In Buffett’s Own Words

We know that we should buy stocks as though we owned the entire business. In his January 18, 1963 letter to investors, Buffett said:

When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate).

So that there is no confusion as to his wording of “the value of assets,” Buffett then went on to show, in part, his calculation of value by presenting the balance sheet and his assessment of value for the company’s net worth (equity).

A Two Company Comparison

Let’s examine two simple businesses (the type we should be investing in). In this case, both companies generate $1 million a year in revenue, $250,000 a year in net income, and $300,000 a year in owner earnings:

To add a little more information, both are consulting firms in the same industry – each with 10 employees, both in the same location (just a city block apart), both having 100,000 shares outstanding, and neither having any long-term liabilities. In fact, except for one critical item (and I’ll get to that in a minute), these businesses would appear to be equal – and their valuations would also be equal.

The Balance Sheets

The one thing that separates these two companies resides on the balance sheet – a building. Company A operates out of a fully-owned, zero-mortgage building; Company B leases office space. Because the annual property tax plus depreciation for Company A is equal to the annual lease cost for Company B, the numbers work out identical. Other minor, but relevant, charges make net income and owner earnings the same.

Their respective balance sheets appear as follows:

As you look at these two companies, which would appear more valuable. Under the “ignore the balance sheet” calculation, the value of that building (and other hard assets that don’t appear in the “excess capital” calculation) would be zero.

The Valuation

Using the F Wall Street valuation, Company A is worth $5.65 million. Using the “ignore the assets” valuation (assuming 10 years of cash flow plus 10x the sale price), the valuation is similar – $5.63 million. (For both, I assumed 10% growth for three years, followed by 8% for three years, followed by 6% for four. Then, 5% going forward for F Wall Street valuation.)

All things being equal, the valuations come out to be about the same. So, is there value in the assets?

The Direct Hit

Again, it is our job to think like business owners. What is the safeguard provided by Company B? That is, if the consulting business goes down the tubes, what happens to your investment? Company B would liquidate and pay shareholders a total of roughly $63. Company A would pay us $513.

Of course, we didn’t pay full price for those assets. We got the building at a discount (part of our margin of safety) and so we expect to recoup more than Company B shareholders.

The Asset Conversion

What if the companies don’t go out of business? Instead, they continue on at the rates assumed (above). However, Company A hires a consultant that tells management to sell the building and swap down to lease office space like its competitor does.

Company A does just that. Now, the company has an additional $450,000 in cash. According to the “ignore the assets” school, the business just became immediately worth $450,000 more because it has “excess” capital, and now they would value the company at $6.08 million ($5.63 million plus $450,000 in excess capital).

Here’s the problem: Company A now looks exactly like Company B, except that Company A converted its building into cash (excess capital). The day before the building was sold, Company A (according to the “ignore the assets” school) was worth $5.63 million (the same as Company B). The day after the building was sold, Company A was worth $450,000 more.

Did the company really increase $450,000 in value? Or, was that value there, and simply ignored? Is Company A worth $5.63 million when it owns a building, but worth $6.08 million when it converts that building into cash?

The Dual Value of a Company

Each company has two values – the assets and the future cash. Some assets are critical earning assets – assets that the company needs to generate owner earnings. Some are non-earning assets that simply add to the value of the company.

If you ignore the balance sheet and assets, you can get caught with your pants down when your business converts non-earning assets into cash, and you pay considerably more for the same business.

We’ll end with another early Buffett quote, this time regarding the Sanborn Map purchase:

This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions. In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than [seventy cents] on the dollar for the investment portfolio with the map business thrown in for nothing.

The take-home lesson: Buffett put one value on the assets and another on the business (or future owner earnings). He mashed them together, and bought a business at a substantial discount. Lest you think that the “investment portfolio” was simply excess capital, had the company been selling for 70 cents on the dollar with tons of money in real estate (that wouldn’t show up as excess capital), it would have still been a great play.

Think Burlington Northern.

A Note From Joe Ponzio

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