James, you asked me why price/net-net is a good ratio. Read along, and you'll see from my argument below why this is so.
I often see analysts talk about the cash held by a company with a beaten down stock price. You'll see them subtract the cash from the market cap, and when that yields a number close to zero, they will say "look, you get the underlying business operations nearly for free because of all the cash that they have." I recently saw this in a MSDW report on a semiconductor equipment stock, for example.
The typical circumstances where this arises is a cyclical tech stock does a secondary offering at the peak of a cycle, so it's loaded with cash. Immediately after the offering, it doesn't have a low price/cash ratio. But that changes. The market then sours, and all the stocks in that sector collapse, regardless of their cash. The stock that did the big secondary stands apart from its peers, though, because now the market cap is not much bigger than the cash held by the company. Such a stock is appealing, if the company doesn't burn cash (however, you must be careful because most stocks with low price/cash ratios do burn lots of cash, and they are much less appealing as an investment).
If you will accept the fact that analysts often do subtract the cash position from the market cap, then perhaps you will also accept the idea of dividing, rather than subtracting, these two quantities. The ratio tells you what the percentage difference is, anyway. The same information is embodied in both quantities. If it's meaningful to talk about market cap minus cash, i.e., percentage of market cap represented by cash, then it's also meaningful to talk about market cap divided by cash, as a ratio.
Now in my previous posts I've been talking not about cash, but about "net-net."
By "net-net", I've been referring to "net current assets" as defined by Graham. It's the current assets minus all liabilities. I view this as a generalized version of cash. In the case of the typical debt-free company that isn't a retailer or apparel maker, the two are often almost the same thing. However, I find net current assets to be more useful than cash, because it consistently takes into account all the working capital and LT debt, not just cash. It's pretty much what the company would fetch if they liquidated tomorrow.
So, following the logic, if you accept the widespread practice of subtracting cash from market cap to measure a stock's value, and if you recognize that you get the same information by computing a ratio rather than difference of these two quantities, and if you recognize that net current assets is a better quantity than cash to measure the liquidation value of the company, then ... you will accept my use of net-net as the denominator in a ratio.
As for what multiple of net-net is attractive, I don't hold to the idea that a ratio of 2/3 is magical, just because Graham once found it to be useful for the market conditions prevalent in his day. If you apply a ratio of 2/3 as an upper limit today, and if you also require that the company should have a reasonably good cash flow situation, as I do, then you will find that your screen will generate only a few very tiny companies with a questionable future. If you relax the ratio 2/3 upwards, to 1.0, in today's market you will find a few stocks with a market cap of over $50 million whre the companies actually have a promising future. I've identified two I found this way, FNDT and CLTK. If you further relax the upper limit for the ratio upwards from 1.0, even larger market cap stocks will survive your screen. The point is that the market works in a way where it prices stocks with richer multiples as the market cap increases, and this is especially true for multiples of the price/net-net ratio. If you do net-net screens yourself, and you apply a market cap limit to the screen, you can easily verify this. Thus, you must decide what market cap stocks you are willing to buy, and then you can find the cheapest stocks, using a multiple of net-net, if you choose.
I use the net-net screen, with a specified upper limit for the price/net-net ratio and specified lower limits for cash flow and market cap. I use this to generate a list of a dozen or so stocks. I don't just buy all those stocks. I use the screen as the first step in picking one or two stocks that are attractive based on many criteria, not just based on the ratio to net-net. This is a scheme for finding attractive cheap stocks, and doing it quickly. |
