Modern Security Analysis: Net Asset Value (Part 3)

“The book value of a common stock was originally the most important element in its financial exhibit. It was supposed to show “the value” of the shares in the same way as a merchant’s balance sheet shows him the value of his business. This idea has almost completely disappeared from the financial horizon. The value of a company’s assets as carried in its balance sheet has lost practically all its significance.” —Graham & Dodd, Security Analysis

The Net Asset Value Way

Below is an excerpt (emphasis added) of chapter six in Modern Security Analysis: Understanding Wall Street Fundamentals, written by Marty Whitman and Fernando Diz.

I haven’t read the book (yet), but I’m currently reading chapter 42-45 in Graham and Dodd’s Security Analysis (as part of CSInvesting’s DEEP VALUE Course) and thought it would serve as a good complement to also read about the views and discussions about net asset value in Marty Whitman’s latests book.

I thought it would be good for myself to keep a few things of what I read on the blog together with my underlinings (see emphasis in bold). This will make it possible to share what I read with others who might have an interest in the same topics as well, and also make it possible for myself in retrospect to easily look up things that I’ve read.

This post is split up in a few pieces (too much text to make it all into one… and you should not stress, so it shouldn’t be a problem I think), each one covering one or two of the sub-topics in the chapter (see contents below).

Enjoy and please feel to share your own thoughts in the comment section. All the Best, Value Invest!

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1The Graham and Dodd View on NAV
The Financial Accounting View on NAV
Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
• Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary


Financial accountants universally seem to subordinate NAV to accounting earnings. Their definition of a “fair presentation” bottoms on a view that earnings ought to accurately reflect results for the accounting period. In Accounting Principles it is stated, “The information presented in an income statement is usually considered the most important information provided by financial accounting because profitability is a paramount concern to those interested in the economic activities of the enterprise.” Herman W. Bevis, former senior partner of Price Waterhouse and Company, states in his book, Corporate Financial Reporting in a Competitive Economy, “If one were forced to choose from among the financial statements which bears most directly upon the stockholder’s primary interest, it would, of course, be the income statement.” And McCarthy and Healy, in their book, Valuing a Company: Practices & Procedures, cite studies in a section titled “Lack of Significance of ‘Book Value’” which conclude that book values, or net equities, “lack . . . significance . . . as a valuation factor.”


We have a different emphasis from Graham and Dodd and the financial accountants. To us, NAV, in virtually all analysis other than predictions of common stock prices for the immediate future, is at least as significant as accounting earnings. And in practice, one is not a substitute for the other. But in choosing a starting point within financial statements for an analysis, NAV seems to us to be the better starting point most of the time than ac- counting earnings.

‘In part, our different emphasis results from different perspectives. Unlike Graham and Dodd and the financial accountants, we believe that a very large part of American businesses are engaged in resource conversion activities: That is, they are not strict going concerns involved only in operations that result in recurring accounting earnings. Rather, many companies, in whole or in part, are engaged in resource conversion activities that give rise to tax shelter, mergers and acquisitions, changes in control, liquidations, investment activities, and major refinancings. In support of this view, we present historical information about the prevalence of certain types of resource conversion activities for the companies in the Dow Jones Industrial Average Index for the five years from June 2007 through June 2012 in Table 6.1.

The analysis of businesses so engaged involves assigning a relatively increased importance to NAV, or in any event a marked decrease in the significance of accounting earnings from operations. In addition, Graham and Dodd and the financial accountants seem to view their constituency as OPMIs who are relatively conscious of, and influenced by, day-to-day stock market price fluctuations that are much more influenced by accounting earnings as reported than by NAV. We, on the other hand, view our basic constituency as creditors and investors, and insofar as we write for OPMIs, it is to recommend that they analyze securities in much the same way as do creditors and investors who are activists or promoters.

We also differ somewhat from Graham and Dodd and financial accountants because we have a different fundamental view about the relationship between NAV and accounting earnings.We believe that whenever accounting earnings are significant in the fundamental analysis of a company, so is NAV. Indeed, in most instances NAV is intrinsically related to earnings and exists in great part because companies or their constituent parts have enjoyed retained earnings in the past. In fact, our studies of stock prices show that when common stocks are selling at low price-earnings (P/E) ratios relative to average historic earnings, the same common stocks tend to sell at lower prices relative to NAV; conversely, high P/E ratios based on average historic earnings correlate with common stock prices that are at substantial premiums above NAV. Of course, there are logical reasons why this should be so.


In the bookkeeping cycle, net income not paid out to stockholders becomes a balance sheet account, called retained earnings or earned surplus. These past profits tend to be the principal component of NAV. Thus, as a rule of thumb, companies with large NAVs relative to market prices have net worths that consist in great part of retained earnings. Such companies tend also to be selling at very low prices when compared with average longterm earnings.

For example, Table 6.2 lists the 30 companies that comprise the Dow Jones Industrial Average, and shows the relation to the price for each company’s common stock on June 2012, of its NAV and 10-year average earnings. Figure 6.1 is a plot of the data in Table 6.2.

This correlation between P/E ratios based on accounting earnings and the relation of market price to NAV has not always been fully appreciated. For example, see the comments of McCarthy and Healy cited on page 184. Yet, we have found that there is a strong tendency for stocks selling at high multiples of historic earnings also to be selling at substantial premiums above NAV. This correlation between P/E ratios and the spread between market price and NAV is not perfect, of course. The correlation does exist, however, as a general rule. Given the integral relationship between historic accounting earnings and NAV, we would be surprised if it did not. To say, then, that earnings determine common stock prices but that NAV is irrelevant clearly makes no sense unless one is talking only about short swing trading and stock price movements.


Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.


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