In the stock market, you may find companies trading at less than the cash it owns. But they don’t neccessarily make good investments. Here’s why.
When I first started investing, the “deep value” style of investing resonated with me. This style involves buying shares in a company that is trading at a discount to its net cash. It seemed like a sensible thing to do.
Buying a dollar for less than a dollar sounded like a common-sense approach that couldn’t go wrong.
But the net cash is just one aspect of a company. The company could be burning cash at unsustainable rates and destroying shareholder value.
In this case, buying said company below its net cash will still turn out to be a bad investment.
Given this, investing in a company should not be based purely on its net cash but on the future cash flows that the company can generate.
How can a company be worth less than the cash it owns?PHOTO: Pexels
This is why I believe that it may even be possible for a company to be worth less than the net cash on its balance sheet.
If a company is burning money every year and management does not make any changes, it will eventually run out of cash. Shareholders will then be left with nothing.
In other words, a company with a lot of cash but a terrible business model that does nothing but destroy shareholder value should very reasonably trade less than its net cash.
The example below can illustrate my point.
Company ABC has $10 million in cash and no debt. However, it is going to burn cash at a rate of $1 million a year over the next 10 years. How much should this company be worth?
Using the discounted free cash flow method and an 8per cent discount rate on future cash flows, the company is worth only $3.29 million. That’s a 67 per cent discount to its net cash.
Valuation screens only tell half the storyPHOTO: Unsplash
So how should we apply this to our investment decisions? I think the key takeaway is that we should not base our investment decisions solely on the valuation of a company.
A company may look cheap using traditional valuation metrics, but in reality, it may not be cheap if you take into account the future cash flow of the company.
For example, even the trailing price-to-earnings ratio may not be a good indicator of a company’s cheapness.
“Trailing earnings” is a historical figure. John Huber of Saber Capital Management brought up a great point in a recent video interview.
In the past, trailing earnings for many companies were a good guidepost for future earnings. This was why the price-to-earnings multiple was used to value a company.
However, the divergence today between future earnings and past earnings is huge.
There are numerous companies being disrupted, while well-run technology companies are building new and rapidly growing markets for themselves.
In today’s world, past earnings may not be a good representation of future earnings for many companies anymore.
How to apply this principle?PHOTO: Unsplash
As investors, our goal is to buy companies at a discount to their real value.
But that value can no longer be derived largely from using metrics such as the price-to-book or price-to-trailing earnings ratios.
We need to look at the company’s likelihood in generating future free cash flow.
Instead of focusing my energy looking at historical ratios, I try to dig deep into a company’s business, its competitive moat, market opportunity, and the ability of management to grow or at the very least maintain said company’s cash flow.
By doing so, I get a better understanding of how much free cash flow a company could generate in the future and the probability it can achieve these projections.
These factors will eventually determine the real value of a company in the long-term, and not its historical earnings nor book value.
This article was first published in The Good Investors.