Ben Graham’s Net Current Assets Value (NCAV) Formula Explained
This article on net current assets value formula was written by Luis Sánchez. Luis is a lawyer and investment manager based in Bogotá, Colombia, who is primarily focused on net net stocks. He uses Net Net Hunter's high performance net net checklist to identify his stocks. Download our net checklist right now for free. Click Here. Article image (Creative Commons) by fdecomite, edited by Net Net Hunter.
Ben Graham once said that he turned to the net current assets formula exclusively to invest his partnership’s money. But, what exactly is this formula? How is it calculated? Why was it so powerful? And, can we still use it today?
The net current assets value (NCAV) formula itself is pretty simple. It simply takes the book value of the current assets and subtracts all liabilities to get a net amount. The formula can be expressed as:
NCAV = Current Assets - Total Liabilities - Preferred Shares
But as you’ll see, there’s a lot packed into this expression, and a lot of nuanced understanding of net current asset value required to make the most of net current asset value stock investing. Understanding exactly how to leverage this measure to earn great returns is certainly worth it -- as Graham turned to these stocks exclusively during his highest performing years.
To help you understand the formula well, we’re first going to break down the formula into its components, then explain each in detail to help you understand what each component is and why it’s important. Next, I’ll walk you through two important variations that modern net current asset value investors have adopted, and lastly we’ll discuss the returns on offer. Ready?
The Net Current Asset Value Formula and Real World Investing
First, a bit of background information is in order. What exactly is net current asset value and why would an investor want to measure it?
A net current asset value is a rough measure of the liquidation value of a company. It is an estimate of how much cash value, before tax, investors could receive if they closed the business and sold off all of its hard assets then paid off the firm's creditors.
Obviously this sort of fair value measure is pretty extreme -- nobody is going to close down Apple or Sysco to sell off their hard assets tomorrow. Rather, this measure is reserved for tiny troubled firms that are facing major business problems and actually may face closure. The measure is an extremely conservative assessment of the minimum value investors could receive if they invested in the company. And -- yes -- some firms actually trade below their net current asset value making them serious bargains.
Graham’s Net Current Asset Value Formula In Depth
As mentioned, Ben Graham turned to NCAV stocks exclusively to manage his partnership’s money -- but what exactly went into his formula and why? As I said, the NCAV formula is pretty simple:
NCAV = Current Assets - Total Liabilities - Preferred Shares
Let’s dig a little deeper into each of these elements…
A balance sheet is where all the magic happens with the net current assets formula. The balance sheet records the accounting values of various assets and liabilities, to provide a final net value known as shareholder equity. It consists of current assets, long term assets, current liabilities, long term liabilities, and shareholder equity.
Current assets (also known as short term assets) are all the assets that a firm expects to sell or use in less than a year in the normal course of business. In other words, these are assets a business expects to convert to cash within one year.
Long term assets (also known as fixed assets) are economic goods that a firm uses to generate income, or holds for value appreciation purposes, and are not expected to be sold in less than a year.
Current liabilities (also known as short-term liabilities) are financial obligations and accounts payable that are due in less than one year.
Long term liabilities (also known as non-current liabilities) are financial obligations and accounts payable that are due in more than one year.
Shareholder Equity (also known as book value) is the owners’ residual claim on a company’s assets after subtracting all liabilities. Importantly, this is an accounting figure rather than real world value. More on this important fact below.
Current assets are usually broken down into:
- Cash and cash equivalents
- Short term investments
- Deferred tax assets
Cash And Cash Equivalents
Cash is simply dollar bills either physically held or deposited in a bank account. Cash equivalents are highly liquid, short-term investments with minimal risk of wide fluctuations in market value such as short-term treasury bills or short-term deposits in money market funds.
Short Term Investments
Short-term investments, also referred to as marketable securities, are financial assets that trade in a public market. These are basically stocks and bonds owned by a firm that can be liquidated in the public market in a very short period of time, but are subject to short-term price fluctuations.
Receivables are bills due from clients to the firm. These assets are recorded whenever a good or service is delivered to the customer and not paid immediately. Receivables are usually due 30, 60 or even 90 days since the date the good or service is delivered. Receivables don’t accrue interest.
Inventories are the goods that a firm has in stock, ready to be sold. Inventory can come from at least two sources. First, the company buys certain supplies and transforms it into a different product -- that’s the case of manufacturers and construction companies, for example. Or, second, the company just buys inventory for resale -- that’s the case of distributors or retailers, in general. The former sometimes record an additional current account called “raw materials” that includes supplies that haven’t already been transformed into inventory.
Deferred tax assets often arise as a result of tax losses in one year that can be deducted from taxable profits in the future -- these are called tax loss carryforwards. On the other hand, prepaid taxes can be subtracted from the actual tax bill accrued in the future. Tax assets are not usually collectable in cash. Instead, they are used to offset future tax obligations. Tax receivables are actually collectable in cash, however.
Long Term Assets
Long term assets usually include property, plant and equipment (PPE), long term investments, intangible assets, goodwill and other long term assets.
Fixed assets usually represent a very high proportion of the assets of capital intensive businesses -- such as manufacturers and industrial companies -- and a very low proportion of less capital intensive businesses -- such as business in service sectors. However, fixed assets are not included in the calculation of NCAV because their market value is rarely close to their accounting value. For example, since accounting rules require firms to depreciate PPE over the course of their useful life, the book value of a 30-year-old paper factory could be close to zero, but its market value could be way higher if the factory is still productive. The same happens with office buildings. On the other hand, goodwill -- i.e., the value in excess of book value of an acquired firm -- could be worth zero in the market, and have a very high book value.
Since their market price could be way above or way below book value, Graham just thought it was wise to exclude them altogether from the NCAV formula. This just added a margin of safety to the calculation -- even if the fixed assets turned out to be worthless, the NCAV wasn’t affected.
Current liabilities include accounts payable, deferred tax liabilities, and financial debt.
Accounts payable are bills due to suppliers and other commercial creditors and they arise in the normal course of business. These liabilities don’t accrue interest, and they are usually due 30, 60 or 90 days.
Deferred Tax Liabilities
Simply put, a firm records a deferred tax liability when a tax obligation is accrued but not yet paid.
Financial debt includes liabilities that accrue interest, usually bank loans, due in less than one year. These include the short term portion of long term debt that is due in less than one year.
To assess the liquidity of a company, analysts calculate the ratio of current assets over current liabilities, or how many time can the current assets cover current liabilities. A positive NCAV and a very high current ratio -- above 2x -- is usually a sign of good financial health.
Long Term Liabilities
Long term liabilities include financial debt, and various provisions for employees and directors, as well as other long term liabilities.
Provisions are accounting estimates of a future obligation and, in that respect, they are subject to some degree of interpretation. Other long term liabilities could include a wide arrange of liabilities that don’t fall in any other category.
Current and long term liabilities together make up total liabilities, and it’s this total figure that net net investors use to calculate Graham’s net current asset value formula.
A positive NCAV reflects a very solid balance sheet. Indeed, if a company can pay all its liabilities using only its current assets and still have something left for shareholders after that, it probably has very little financial debt, a fairly high current ratio, and very high liquidity.
Preferred shares should be subtracted from the value of current assets too because preferred shareholders are entitled to a fixed dividend payment and have the right to be paid before common shareholders in the event of a liquidation. Preferred shares are liabilities for the issuer.
Shareholders’ Equity includes the value of capital, and retained earnings, and it reflects the residual claim that investors have on a firm’s assets. Book value is often considered a proxy for liquidation value -- after all, in theory, investors are entitled to book value in the event of a liquidation. However, as we discussed above, the book value of fixed assets does not reflect their market value, making book value a very inaccurate estimation of intrinsic value. In this sense, the NCAV is just a conservatively adjusted book value.
Net Current Asset Value Formula Problems
Graham’s NCAV formula is not without its problems.
First, as you know, the formula is a rough estimate of liquidation value, not an exact measure. The nature of assets held by various companies differ considerably from one firm to the next. While the value of cash is not affected in a liquidation, the value of receivables may be lower than their stated balance sheet values for some firms but not others. Inventory values can prove to be higher or lower than the value stated on the balance sheet depending on the type of inventory the firm holds. Again, the formula also completely excludes fixed assets, prioritizing conservatism.
Fire Sale Liquidations
A similar problem comes when the firm conducts a “fire sale” liquidation -- a scenario when management rapidly liquidates the firm’s assets. In these scenarios, all account values aside from cash and cash equivalents may prove too rosy of an assessment.
Another limitation is the nature of the valuation approach itself. NCAV can be too conservative an estimation of fair value since a going concern is worth way more than just its liquidation value. Net net investors usually just sell when the price approaches NCAV, and they usually lose the rest of the way up.
Two examples immediately come to mind. The first is with businesses that sell services instead of tangible goods. Since there companies don’t record inventories on their balance sheet, their NCAV may seem negligible compared to the NCAV of a manufacturer -- yet, services can be worth way more than tangible goods. Another example are rare firms that combine good operating businesses, growth, and very low PE ratios of maybe 4 or 5x. These do exist, and they’re worth quite a bit more than liquidation value. Finally, some firms have significant intangible assets, so ultimate liquidation value would be much higher. Tiffany (the diamond jewlery company) was a net net in the 1980s, despite its tremendous brand.
Off Balance Sheet Items
However, there’s a more important limitation. More often than not, accounting rules don’t mandate some liabilities to be included on the balance sheet but only revealed in the notes to the financial statements. The simple NCAV formula doesn’t include this off-balance sheet items. Sometimes these off-sheet liabilities have a material impact and turn NCAV into a negative figure -- a firm with a negative NCAV is not a net net.
Net Current Asset Value Formula Adjustments
The shortcomings of the NCAV formula have some implications in the real world.
Since the NCAV formula tends to underestimate rather than overestimate the liquidation value of firms its inaccuracy works mostly in favor of net net investors. Also, keep in mind that only a small proportion of companies selling below NCAV actually close shop. Even if a net net goes bankrupt, fire sale liquidation scenarios are the exception, not the norm.
In any case, to minimize the risk of overpaying or being wiped in a fire sale liquidation scenario net net investors just diversify extensively. Graham held around 100 net nets at any one time.
But let’s say that in any particular case the liquidation is imminent and you want to estimate what you could get after all liabilities are paid. In this case, Graham would also employ his net net working capital formula, which took into account a percentage of fixed assets -- yet, Graham’s stance was that, on average, any value lost during the liquidation process would be made up by the value of long term assets.
Remember, NCAV is just a proxy for liquidation value. By excluding fixed assets the analyst just adds a margin of safety to his estimation of liquidation value.
Finally, to account for off-balance sheet liabilities, the NCAV formula should be stated as follows:
NCAV = Current Assets - Total Liabilities - Preferred Shares - Off-Balance Sheet Liabilities
This is a more conservative and accurate version of Graham’s NCAV formula. In practice, most modern net net investors employ this adjustment so as not to overstate liquidation value.
NCAV Formula: Final Considerations
Even if you master the NCAV formula and decide to invest in net nets, screening net nets among the universe of stocks around the world is no easy task.
Net nets -- i.e., stocks selling for a price below NCAV -- are often troubled, ugly, forgotten stocks. Most of them deserve their very low prices because their managers are crooks, or because their business or industry is facing insurmountable problems that are quickly eroding NCAV.
Graham was well aware of these problems. A low price to NCAV was just the initial filter for him. After that, he wanted to find reasons to believe that the net net firm could at least survive, or even grow modestly. A very low debt to equity ratio, history of profitability, and high current ratio, were some of the additional criteria he used to find high quality net nets. Managers or insiders aggressively buying the stock was also probably a good sign.
Graham earned 20% a year for three decades buying hundreds of high quality net nets. After he realized these sub-liquidation stocks worked out so well, he quit the other investing strategies he used such as arbitrages, hedges and special situations.
Walter Schloss followed Graham’s advice, and earned 16% a year on average for more than three decades. Warren Buffett invested his partnerships’ money in net nets as well, yielding a 30% return a year on average for 13 years -- quite an accomplishment, and the reason he became a millionaire in the first place. Buffett even wrote in his 2014 shareholder letter that his “cigar butt” method of stock selection (ie. net net stocks) earned him the best returns of his career.
Also, there’s ample academic research available supporting the hypothesis that a group on net nets offer outstanding returns above the market averages in the long term.
In sum, the NCAV formula is a very useful tool for investors to identify groups of stocks that are probably undervalued. Among that group, investors should apply additional criteria to identify the real bargains, and avoid value traps. I use Net Net Hunter for that purpose. The monthly shortlist members receive is a good place to start looking for high-quality net nets -- and I’ve found quite a few!