25 Jul 2015

Metrics for Valuing Companies

For a while now, I’ve been confused about the various measures of a company’s book value. It doesn’t help that financial accounting uses a whole bunch of terms that aren’t very consistent. Here, I hope to consolidate in a single place, the most commonly used measures. I make no claim for being innovative or original - most of the material is copied off Wikipedia or Investopedia.

Book Value (aka Net Asset Value)

Calculation: Total Assets - Total Liabilities

Basic idea: This to me is the most intuitive measure of the value of the a company’s assets. It basically measures what the common stockholders would receive if the company were to be liquidated.

There is also a more stringent version of book value called “tangible book value” in which intangible assets such as patents, copyrights, franchises, and goodwill are substracted away. In a way, this makes sense because these are items for which there is no well-defined liqudation value.

Once again for clarity: Tangible Book Value = Total Assets - Intangible Assets - Total Liabilities

Net Current Assets

Calculation: Current Assets - Total Liabilities

Basic idea: Popularized by Benjamin Graham, net current assets is a more conservative form of book value in which current assets are used in place of total assets.

Current assets are assets reasonably expected to be sold, consumed, or exhausted through the normal operations of a business within the current fiscal year or operating cycle (whichever period is longer). This includes items like cash, cash equivalents, short-term investments, accounts receivable, and stock inventory. In constrast, non-current assets (also called fixed or long-term assets) are anything of monetary value that represent future benefit to the business for period no shorter than 12 months. Examples are land, building, car, machinery, plant and equipment.

Hence by using net current assets instead of book value, we’re essentially putting aside the fixed assets and using them as a margin of safety. Graham considers a stock a “bargain issue” when its net current asset value is 1.5x its price.

Working Capital

Calculation: Current Assets - Current Liabilities

Basic Idea: By using current liabilities, we don’t consider the long-term liabilities of a company such as debentures, loans, deferred tax liabilities and pension obligations. As such, this isn’t really a good measure of a company’s book value so much as a measure of its capital efficiency and short-term financial health.