If you're going to understand only one financial indicator of a company's intrinsic value compared to its market price, Net Current Asset Value Per Share (NCAVPS) is it. It's not a terribly difficult concept to master, but understanding it completely is one of the best ways to get a basic fundamental understanding of what it means to be concerned with value investing.
Value investing, at its core, is the search for investment opportunities in which the current market price of a security lies beneath intrinsic value. As with most indicators, NCAVPS cannot be considered in a vacuum when purchasing securities, but if I was forced to choose one indicator alone to rely on, this would be it. So take your time through this explanation.
First, what is Net Current Asset Value?
[Net Current Asset Value] = [Current Assets] - [Total Liabilities]
Net Current Asset Value, or NCAV, is a very simple value to calculate and by itself is not incredibly useful to the value investor. It is simply the difference between a company's current assets over its total liabilities. Essentially, all we can tell from the NCAV is to what extent a company's total liabilities can be satisfied by its current assets (i.e. cash, investments, accounts receivable, inventory etc.).
In other words, were the company forced to liquidate immediately (in an orderly fashion, but quickly), how much of a company's liabilities can be satisfied by its current, liquid assets without the need to liquidate long-lived assets such as land, buildings, equipment, long-term notes receivable, etc.
You will find companies on both ends of the spectrum here. Some companies can more than cover all of their liabilities with current assets and still some other companies could barely make a dent. While you can get some vague idea of a company's overall financial health from the NCAV, no significant investment decisions can be made solely based on this measure.
Here is where it starts getting interesting, though. Once you've found the Net Current Asset Value, you can then calculate...
Net Current Asst Value Per Share
[Net Current Asset Value Per Share] = [Net Current Asset Value] / [# of Shares Outstanding]
So, for example, assume the following facts about a company:
Current Assets: $100 million
Total Liabilities: $30 million
Shares Outstanding: 10 million
We would calculate the company's NCAVPS as follows:
Net Current Asset Value Per Share = ($100 - $30) / 10
Net Current Asset Value Per Share = $7 per share
This means that there is $7 of Net Current Asset Value for ever 1 share of the company. Or, put another way, if the company liquidated today, there would be $7 left over after satisfying all liabilities for every 1 share of stock. Remember, this is before taking long-lived assets into account. We are only considering current assets.
With this information, I know that if I were to purchase a single share of this company's stock today for $7 and the company subsequently liquidated on the same day, I should expect to at least break even before considering the salvage value of the company's long-term assets.
What we are looking for then are stocks that are currently priced below NCAVPS. Based on the example above, suppose that the company was trading at $5 per share instead of $7. In simple terms, buying one share of that company would get you an immediate return on investment of $2 or 28.5% (assuming instant liquidation, of course).
It was Benjamin Graham's idea that investing solely in companies trading at or below 67% of its NCAVPS would prove to be very profitable for investors and later independent research studies have shown this to be essentially true. And while there certainly are no completely fool-proof plans, a NCAVPS strategy probably comes as close as you can get to one.
A word of caution, however. Having read this does not automatically make you the next Warren Buffett. Diversification is still important and a sound understanding of the securities in which you invest is essential. Buying the stock of a company tail-spinning out of control is never a good idea no matter how far below NCAVPS it is trading. My advice is take what you've learned here as a starting point for further research and study. Knowledge is power, but a little bit of knowledge is dangerous.
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