Once in a while, I get a message or an email, with a certain company name that has a price/book ratio below 1, and the question at the end is “What am I missing” or “Does this make sense”?
The goal of this post is to elaborate on why a low price-to-book ratio doesn't necessarily mean a company is cheap. The post is divided into the following segments:
– The theory
– Example – Big Lots
– Going concern
– Conclusion
The theory
The theory is quite simple. If a company has a price-to-book ratio of 1, the market price is in line with the book value of the company.
If the ratio is below 1, you can buy the book value of the company for a lower price. Should you buy a company with such a ratio, you get more than what you pay for (in accounting terms).
On the other side, if the ratio is above 1, you'll be paying a premium compared to the book value.
I've bolded a couple of words, and that's where the catch is.
Example – Big Lots
Although the theory is simple, the practice is not so much.
Let me introduce you to Big Lots, a furniture & home decor retailer.
Its market cap is roughly $210m. Let's assume that you have the option to buy the entire company for $250 (a premium is often paid for a transaction of this type). This is the price.
If you take a look at the book value (which is total assets minus total liabilities), that is equal to $550 million! This is the book value.
Based on these two numbers, we can calculate a price-to-book ratio of 0.45.
So, can you not buy the entire business for $250, sell all the assets, pay all the liabilities, and collect the remaining $550? In this case, we assume that the book value is equal to the liquidation value.
Imagine that you've done this. You've paid $250 million and now you own Big Lots. Now what?
Let's see what that would look like in practice: Big Lots has total assets of $3.66 billion and total liabilities of $3.11 billion.
The 3 big buckets when it comes to assets are:
– $1.1 billion of inventories
– $1.5 billion of operating leases (Right-of-use assets)
– $750 million of property, plant, and equipment
This explains over 90% of all the assets. So, how can this be converted into cash, so the liabilities can be settled, and you are left with $550 million?
Inventories
How can one get rid of $1.1 billion of inventories? There are two main ways:
- As this is a retail company, you can choose to sell them through regular business operations. The catch? The company is not profitable. Over the last quarter, it sold $730m of inventories for $1.1 billion in net sales and reported a net loss above $200m. To sell $1.1 billion of inventories, it would take around 5 months, and it is quite clear that the outcome will not be $1.1 billion in cash, but closer to $700m (assuming the company losses $400m throughout these 5 months). But imagine what this would look like. You have all the stores with 100% inventory, then 80% inventory, then 50% inventory, then 20% inventory. It is unlikely that the inventory will go down to 0 unless special discounts are offered. Which means the $700m mentioned above, might be an overstatement.
- You could call a competitor, and offer them the inventory. You'll likely hear a positive answer and an offer of $500m or $600m. Wait, you might ask, isn't the book value $1.1 billion? How come the offer is so low? Big Lots paid $1.1 billion to the manufacturing companies, to buy the inventory and have it delivered to their stores/warehouses. The competitors can do exactly the same, for the same price. In addition, the competitors don't have to order $1.1 billion at once and tie a lot of their capital. They could order a lot less. Therefore, you, as the new owner of Big Lots, have no negotiation power.
Already, you can see that the book value is not equal to the liquidation value. This is only one of the three main assets of the business.
Operating leases (Right-of-use assets)
The previous owners/managers of the business, have signed numerous leasing contracts (for properties, equipment, vehicles, etc.) and these assets provide value to Big Lots. Canceling these contracts would also remove the lease liability on the other side of the balance sheet.
So, this should be straightforward, right? Not really, no.
To expect that you can ring anyone, and cancel the contract “as of tomorrow” is unreasonable.
There will either be a notice period or a cancellation fee/fine.
Property, plant and equipment
At least this one should be easy, right? Well, I have some bad news.
Selling land & buildings in today's market might not be the most difficult task. But how about all the equipment and vehicles that the company owns? I'm referring to the small ones such as stalls and cash registers, all the way to their forklifts and delivery vehicles.
To get rid of them on short notice, you'd have to sell them at a discount.
What else is missing?
This is not all. How about the employees? Liquidating a company of this size will not happen without severance pays.
Going concern
So, why do we have those book values if they don't represent the liquidation value? Because there is something called “going concern”. It is a fundamental assumption, that the company (in this case Big Lots), will remain operating into the foreseeable future, rather than undergo a liquidation.
Therefore, the financial statements have been prepared on a “going concern basis”.
Conclusion
This is a simple example, that illustrates how different the liquidation value might be compared to the book value. Imagine if there was $1 billion of goodwill on the balance sheet. That's not something that you can sell.
Let me be clear, this post has nothing to do with Big Lots and its value. It is solely here for educational purposes. There are plenty of scenarios that could happen to the company in the future. It could become profitable again, it could get acquired, it could go bankrupt, or it could be in a tough spot for a long time.
On the other side, think of companies with high price-to-book value in the tech industry. These companies do not have to invest heavily in assets, so using the price-to-book ratio is completely pointless.
I hope you enjoyed this post, and as always, thank you for reading it until the very end.
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