In a class early last academic year, I drew a quick diagram for students to summarize valuation between the balance sheet and income/cash flow statements: simply three blocks making up a horizontal bar. The first block was net tangible equity, the second was intangibles that added value to the company and the third represented the future cash flows that the company was likely to produce according to reasonably constructed financial models.
As we move from the left to the right, things change. Net tangible book equity is on the balance sheet right now and can, assuming financial statements are represented fairly, be valued rather easily. Intangibles are more difficult to measure as some, such as goodwill, are effectively worthless while others are intertwined with future cash flows and can not be liquidated easily. Certainty increases moving from right to left and upside for investors changes in the opposite direction. Future negative cash flows would eat away at tangible assets (cash hemorrhaging or "right folding" effect) and would therefore easily explain why many unprofitable public companies are priced at discounts to tangible equity.
With so many companies leveraged to the tilt, there's an "equity crater" that needs to be filled by future cash flows and/or valuable intangible assets. Many public equities are, on a pure balance sheet basis, worth less than nothing. As a shareholder with limited liability, an investor is not on the hook for that negative equity, but the overall market equity value of the firm, which depends on those future cash flows, is effectively in a hole. Let's try a simple example with two firms with the same estimated amount of valuable intangibles and identical future free cash flows. One has positive net tangible book value of equity and the other has a negative amount with the same absolute value. All things being equal, the value of firm two is less than firm one by two times the net tangible book equity value in question. It's simple to understand but has important consequences, particularly in a market when access to capital is not as easy as it once was.
The equity crater needs to be filled by additional future cash flows for firm two. Unless a company has a strong, acyclical business, massive valuable intangibles, superior access to the capital markets or a business franchise with plenty of market advantages, this could mean trouble ahead. Investors should employ a healthy dose of skepticism when examining companies with non-positive basic, balance sheet value. Real assets backed by equity have immediate value for the shareholder. Proponents of Modigliani-Miller will often minimize the importance of net tangible equity and emphasize the idea that a firm's value is maximized when weighted average cost of capital (WACC) is minimized. In this era of incredibly high leverage and uncertain debt markets, the probability of financial distress that has been used in this methodology has underestimated. Likewise, so has the value of a solid balance sheet.
With that in mind, let's consider looking at three major indices, moving down the market capitalization spectrum and examining tangible equity. In the first scenario, looking at mean/median values of net tangible equity and the percentage of each index with negative values. Factoring in non-goodwill intangibles in the second scenario gives a slightly less conservative balance sheet view. The results below show an increase in tangible equity averages as market capitalization decreases. The Russell 2000 small cap index (IWM) shows better overall balance sheet health than the big, and often overused, DJIA 30 (DIA) as well as the S&P 500 (SPY). The addition of intangibles adds more to the larger indexes, which is intuitive when considering that larger companies have much more value in the form of intellectual property, acquired brands and other valuable intangible assets.
As a company's market capitalization increases, so does the size of the equity crater. Large caps are more heavily leveraged, but, they also have greater, more stable cash flows, right? Not necessarily. While the percentage of firms with negative last twelve months free cash flow is significantly higher for the Russell 2000, mean/median LTM FCF yields are comparable with the S&P 500. When considering an individual company within these indices, particularly the broader S&P 500 and Russell 2000, these metrics can be used to quickly gauge where a given index component stands in terms of balance sheet and cash generation capability. For example, the presence of a relatively large equity crater has been one of the contributing factors behind recent debt and equity downgrades of DJIA and S&P 500 component Boeing (BA), which, despite its very strong market position, has negative net tangible equity of $6.235B (negative $3.508B including intangibles) and levered free cash outflow of $4.283B.
Putting the pieces together, this tangible equity and free cash flow approach can then be used derive relative valuation. Below, the second mean book equity values have been added to FCF yields at a multiple that produces current market valuations. With nearly three times more components of the Russell 2000 having negative net equity plus LTM free cash flow value, risk within the small cap index appears to be greater. However, the multiple used to match market values is nearly 2x lower. Is the market correctly pricing risk across the capitalization spectrum? My belief is that this analysis shows that it is not. Small caps, particularly small cap value, still possess the most compelling valuation in the current market and have historically been the strongest performers over the long haul.
As large caps have levered up while small caps have cleaned up their balance sheets, the equity crater effect is now generally having a greater impact on larger companies that have embraced the "firm value maximizing" principles of Modigliani-Miller touted by pure academics. Those principles, while well intended, never anticipated the market events of the past two years. The chart below shows the percentage of companies in each index with negative net tangible book value of equity (excluding all intangibles) over the past ten years (2009 is LTM). If the deleveraging whirlwind is to continue, it appears as though small caps are best positioned.
For this reason, I believe it is worthwhile to search the small and micro cap universe for value. In previous posts, I have attempted to identify both balance sheet and free cash flow based compelling smaller companies that don't fall victim to the equity crater. Later, I hope to examine a few small cap stocks that may be suffering from this effect. Whatever your market capitalization investing bias may be, beware of the crater.
Disclosure: The author does not have positions in any of the mentioned securities at the time of this writing.