view of liabilities in value investing
Liabilities & Equity are the sources of fund that support the assets. To determine the company value based on the reproduction cost of the assets. Knowing how much money an investor or business person would have to lay out to acquire or replicate those assets is very important. So, value investors need to examine the liabilities side of the balance sheet to see what to spend.
Refer to Greenwald, et al. there are three categories of liabilities:
Liabilities that arise intrinsically from the normal conduct of the business. They include a/c payable to suppliers, accrued vacation, other wage costs due to employee, accrued taxes due to government and other accrued expenses. Current liability also belong to this type, which is usually due within a year and bear no interest.These liabilities are easy to be found, we only need to substract the liability book value from the reproduction value of assets to arrive the reproduction value of the net assets.
Liabilities that consist of these obligations that arise from past circumstances that are not pertinent to a new entrant. Examples are deferred tax liabilities and liabilities incurred because of adverse legal judgements such as "the company broke the law and owes fines or settlement payments". They are irrelevant for the new comers. The tax law may have changed, or this firm's experience may effectively deter the new people from making the same mistakes. These liabilities will not reduce market value a potential entrant has to make. They are genuine obligations that will have to be paid, they do need to be subtracted from the asset value to see what this firm is worth to investors.
Outstanding formal debt of the company. Asset value after being subtracted by the first two liability categories is the asset value which investors have claims. This value will be divided between those who hold the debt and those who own the equity. If we are shareholders or making equity investment, subtract the debt value (Use market debt value, if unavailable use book value of debt) from the remaining asset value. The value of debt should be solid, except in situations of financial distress.
In a highly leveraged firm (e.g. lehman brothers), where debt accounts for a large share of the asset value of the enterprise. A slight error in estimating the asset value will have a major impact on the equity value.
For example A = 100M, D = 80M, E = A - D = 20M
If 10% off, A'=90M [100*(1-0.1)] E'=A'- D = 90M - 80M = 10M
Change in Equity = 100% * (E' - E)/E = -50%
= > Margin of safety (MOS) may be eliminated.
Leverage can be the foe of the MOS, many value investors shy away from company that have high debt level.
Another way to treat the debt is to consider it alongside the equity as part of the market value in the company <- Enterprise Value Approach
Enterprise Value = MV of debt + MV of equity - Cash
If we compare the AV (Asset Value - Sponstaneous & circumstantial Liabilities) with EV (Enterprise Value). And if AV > EV + MOS, then it means good investment opportunity for value investors.
Reference:
Greenwald. B. C. N. & Kiviat. B. (2001). Value Investing: From Graham to Buffett and Beyond. Wiley.
