Liquidation Value

The second part of my valuation system is to look at the liquidation value. To calculate liquidation value, I simply use the model described by Graham in Security Analysis: 1 x cash + 0.8 x accounts receivable + 0.67 x inventories + 0.25 x tangible fixed assets. Graham actually offers up .15 as the "rough average" for fixed assets, but I upped it to 0.25. He offers a range of from 1 to 50%, and I thought I'd use something in the middle of that.

Obviously, this is a very crude estimation, but should be effective for screening large quantities of stocks. An example of a more intricate methodology, practiced by Marty Whitman's team over at Third Avenue Management, is outlined in this article.

Once we have the liquidation value, we can compare that to the market price of the shares plus all outstanding liabilities. Let's call this Full Enterprise Value (FEV), as opposed to Enterprise Value (EV) which normally includes only debt from the liabilities and deducts any cash balances. In other words, if we bought up all the shares and then paid off all the outstanding liabilities, we should own all the companies assets, at which point we could realize the liquidation value. I generally divide the FEV by the liquidation value to come up with a "balance sheet multiple." (I guess I need to work on some catchier names for these metrics) which would be analogous to the commonly used price-to-book ratio, but hopefully a little more meaningful.

Putting It All Together
Once I've derived the cashflow multiple and the balance sheet multiple, my next step is to multiply the two together to come up with an "overall value" (OV) rating. The lower this number, the better value the stock represents. Overall value ratings below 20 often represent very good bargains and are the primary vein I use to mine for good stocks. However, certain characteristics, such as company size, stability of cashflows, the competitive advantages of the business, etc., can justify higher valuations and there may well be very attractive bargains found at higher levels. In any event, once you're down to a manageable list of possible value stocks, the next step is to look at each stock in more detail, examining the financials and the news reports closely, to verify that the numbers are correct (again I use MSN data and it occasionally has errors) and to get a better feel for what the future might hold. Is the company teetering on bankruptcy? Were the significant cashflows of the past 5 years generated from a now-spent mine or oilfield? Has the company sold off significant divisions or made a recent acquisition? Has there been a significant change to the balance sheet since the last financials were reported? Etc., etc.