The Negative Equity (NAV) Conundrum
If A Business Appears To Be Underwater, Is It A Bad Business?
The renowned investor Benjamin Graham, mentor to Warren Buffett, sought out "net net" investment opportunities. This strategy involves identifying companies whose net asset value (NAV) exceeds its market capitalization. The premise is that such companies are clearly undervalued; even if they ceased operations and were liquidated, their assets would cover all liabilities, leaving a surplus greater than the investment. Taking this concept further, if an investor could acquire the net assets of a business for less than their actual value while the business remains operational, they are essentially obtaining the business for less than nothing.
It makes perfect mathematical sense.
So what should we make of the opposite situation: a company that operates with a negative NAV, where its total liabilities exceed its total assets?
Should these companies be avoided by investors?
We typically associate insolvency with a negative net worth position, but these companies are often far from insolvent. Companies such as Amazon, Dell Technologies and Starbucks have all operated with negative equity at times.
Let's explore this further to make sense of it all. We'll find that negative equity can be significant in some cases, while in others, it may not matter at all.
When Negative Equity Doesn’t Matter
The key to rationalizing the negative equity paradox lies in understanding the nuances of corporate finance and the different ways a company can finance its operations and growth.
In a leveraged buyout, a company is acquired using a significant amount of debt financing. This can result in the company's balance sheet showing high liabilities and a negative equity position, even though the company may be highly profitable and able to service its debt. The negative equity is a result of the financing structure, not necessarily a sign of insolvency.
The $17.4 billion acquisition of Dell Technologies by Silver Lake Partners in 2013 was a highly leveraged deal, leaving Dell with a negative equity position on its balance sheet for several years post-buyout. Since then, the company's net asset value has fluctuated between positive and negative, currently reflecting -$2.4 billion in negative equity.
Today Dell Technologies reports an impressive return on invested capital (ROIC) of 24.5%, but are popular profitability metrics reliable when shareholder equity is being destroyed?
When a company has a negative NAV, both RoE and ROIC calculations can produce a negative value, which is impossible to interpret meaningfully. It follows that as the shareholder equity of a business is being eroded and tends towards zero, this kind of profitability metric tends towards being useless.
As equity declines, these profitability ratios will appear artificially high even if the company's actual performance is poor, giving a false impression of good returns.
More concerning is that negative equity can indicate financial distress, which these metrics disguise. This can lead an investor to overlook important risk factors resulting in misleading conclusions about the firm's financial health and investment quality.
In the case of Dell Technologies, various strategic moves and financial improvements collectively contributed to Dell Technologies turning from being a loss making business into profitability around 2019. Accordingly, despite several market drawdowns including the Covid19 dip of 2020, its share price has nearly doubled over the past five years, delivering a compound annual growth rate (CAGR) of 14.1%. So, in this scenario, where debt is manageable and has been significantly reduced—from $46 billion in 2019 to $15 billion currently—investors have fared relatively well despite the negative equity situation.
The key point is that a negative equity position, while often seen as a red flag, does not necessarily mean a company is insolvent or at risk of bankruptcy. The company's ability to generate sufficient cash flow to service its debt obligations, fund its operations and its growth must all be considered. Considerations about its ability to access additional financing, and the nature of its business model are also important factors when evaluating the company's financial health.
A similar situation arises for companies, particularly in high-growth industries, which choose to finance their expansion primarily through debt rather than equity. This can lead to a temporary negative equity position as the company invests in assets and growth opportunities.
An example might be an asset-light business, such as a software company or service-based business, which may have a significant portion of its value tied to intangible assets, like intellectual property or brand value, which may not be fully reflected on the balance sheet. Amazon is such a company and it operated with negative shareholders' equity back in 2004 when its net asset value was recorded as -$227 million. Hindsight is a wonderful thing and we now have confirmation that almost a quarter of a billion Dollars of negative equity should not have been construed as a red flag. Amazon has since generated outstanding shareholder returns as it has gone from strength to strength.
In other situations, a company's liabilities may only ‘appear’ to exceed its assets, leading to the impression of negative equity on paper, but the company may still be highly valuable and solvent. Think about Coca-Cola, a company which uses a recipe that is close to 150 years old. The value of that secret recipe is huge, yet it isn’t reflected anywhere on the Coca-Cola balance sheet. If it was ever acquired by a third-party, ‘Goodwill’ as an asset appears out of nowhere according to accounting standards, and this invariably plugs the gap on the balance sheet of the company making the acquisition. In truth, the invisible asset that we term Goodwill always existed and so it is the accounting standards with the deficit rather than the business.
We've discussed situations where negative equity isn't a significant concern, but there are other instances where it can be a warning sign that investors should take seriously.
When Negative Equity Can Be A Red Flag
When a company repurchases its own shares, it is using balance sheet cash—an asset—to buy back a portion of its outstanding equity. This can be a sound strategy when the company believes its shares are undervalued, as the value it receives exceeds the price it pays.
Mathematically, if the price paid for the equity matches its intrinsic value, both sides of the balance sheet decrease by the same amount, resulting in no change to the company's net asset value.
However, if the company pays a premium—meaning it pays more than the intrinsic value of the equity—it is effectively trading one Dollar in cash for equity worth less than a Dollar. This is a poor trade, leading to an erosion of the company's net asset value.
The decision to engage in share buybacks should be grounded in a thorough analysis of the company’s intrinsic value, growth prospects, and potential alternative uses for the capital. Indiscriminate or excessive buybacks at inflated prices are not in the best interests of long-term shareholders, and such poor capital allocation decisions suggest either mediocre or self-serving management.
Self-serving insiders often grant themselves excessive stock-based compensation, on top of substantial salaries, and then repurchase shares to offset the dilution to external shareholders. Since stock-based compensation is granted regularly, the offsetting buybacks must occur at a similar frequency, regardless of the prevailing market price.
Apple serves as a notable example. In recent years, the company has allocated approximately $20 billion annually in stock based compensation to insiders. The trade to offset dilution occurs several years later when the vesting period expires, by which time the value of the shares has been inflated (more on this later), so the cost to the business is ultimately far greater than the value of the initial grant. This practice has persisted over the past decade, with the value of stock based compensation spiraling to unconscionable levels, which has eroded shareholder equity from around $140 billion to approximately $60 billion today (see chart below).
The eroded equity has found its way into the pockets of insiders - this practice is tantamount to a wealth transfer from shareholders to self-serving insiders. Where are the regulators, supposedly charged with safeguarding investor interests, while this great heist was happening? Good question!
Perhaps regulators have not engaged because the external shareholders raise no complaint. Why not? The answer, quite simply, is that this scandal has all been occurring behind smoke and mirrors. It has been disguised as a good thing for investors when in truth it is anything but.
This is how it goes down. A lower share count due to buy-backs makes the EPS appear stronger, which Wall Street blindly celebrates every quarter. At the same time, tens of billions of Dollars of ‘artificial’ demand for the shares flowing from the repurchase operation elevates the share price. Concurrently, while the share price appears to be outperforming the market there are fewer willing sellers than may otherwise be the case. So this distorts the market by skewing supply and demand. Then, a higher market cap results in a larger weighting of the company in the S&P500, compelling passive investment fund managers to buy more shares, notwithstanding the underlying fundamentals of the business and regardless of price (passive investing is dumb money!) So another factor exerts upward pressure on the share price and this momentum, together with FOMO, results in more outside investors buying at over inflated prices pushing the share price higher still, at which point the company is ready to buy the next tranche of equity to offset dilution on the latest egregious grant of stock based compensation. So the fly-wheel keeps spinning, arguably out of control.
The market cap of Apple went from about $600 billion to $3.5 trillion in around 6 years, that amounts to a CAGR of more than 42%. Over the same period, its TTM revenue has increased from $247 billion to $381 billion (9% CAGR) and net earnings from $56 billion to $100 billion (12.3% CAGR). The maths doesn’t stack up, but you now know how this miracle happened! Smoke and mirrors. Distortions of the market.
These distortions were called out a few years ago by Deutsche Bank Global Research (the chart below shows in the red line how non-financial corporations, which are companies buying back their own shares, grew from being insignificant in 2009 to creating $4 trillion worth of artificial demand by 2019).
Source: 10.slok_.pdf (berkeley.edu)
In the case of Apple, the company has been extremely aggressive in its share buyback program, repurchasing hundreds of billions of dollars' worth of its own stock over the past decade and destroying a corresponding amount of shareholder equity along the way. It has attempted to justify these buybacks as a way to return capital to shareholders, but you now know the truth. This is far from being about doing what is best for shareholders. In fact, the sustained nature of Apple's buyback program, indiscriminately repurchasing shares regardless of price and most often at over inflated prices, is tantamount to rewarding investors who exit the business at the expense of those that remain invested! Does that make sense to you?
It is rumored that this was an influencing factor in Berkshire Hathaway’s decision to divest more than half of its holding in Apple to date, and it probably isn’t done selling yet.
Starbucks is another interesting case study. To finance its aggressive share buybacks, Starbucks took on substantial amounts of debt. This increased the company’s liabilities while reducing its equity. In combination this pushed the company deeper and deeper into a negative equity position from 2019 (see below).
As shown in the red box below, the repurchases of stock occurred at peak prices at times when the company was capitalized at an eye-watering 5x top line revenue and over 33x earnings against net margins averaging close to 12%. In other words, Starbucks was paying prices well above the intrinsic value of the equity it was acquiring.
Despite top line revenue growing at about 11% annually over this period, and despite margins remaining relatively stable, the share price stagnated, showing a negative 0.2% annual return over the period. Its dividend yield has averaged around 2% so annually a shareholder would have seen a total return of around 1.8%, but in real terms, accounting for inflation, this is a negative number.
This lackluster performance can be attributed to several factors. The balance sheet has been weakened as long-term debt has surged from $2 billion a decade ago to nearly $16 billion today. The rising interest expenses required to service this debt have exerted downward pressure on profitability, significantly dragging down net earnings. Over the past five years, net earnings have consistently been lower than they were in 2018, before the negative equity situation arose (see chart below).
The number of shares outstanding has declined (see chart below), but is this returning capital to shareholders? Or has it been a huge waste of corporate capital? Billions of dollars of balance sheet cash has been spent in order to achieve what exactly?
Despite declining corporate earnings, the reduced share count has boosted EPS numbers, something that management proudly points out at every quarterly earnings release. Quite incredible, but par for the course these days!
Essentially, Starbucks management has completely mismanaged capital allocation.
But why?
As Charlie Munger used to say, “Show me the incentive, and I’ll show you the outcome.”
Poorly designed management remuneration plans place focus on the wrong metrics. Starbucks has moved away from tying executive bonuses to Diversity, Equity, and Inclusion (DE&I) goals, and other ‘metrics du jour’ from a few years ago. It has since shifted its executive compensation structure to focus more on financial performance, with 75% of bonuses now tied to financial targets, such as EPS and revenue growth. It should come as no surprise that despite the underwhelming performance of this company from an investors perspective in recent years, both EPS and top line sales are up and management has qualified for its large bonuses!
Declining shareholder equity in the case of Apple and negative equity in the case of Starbucks are significant red flags for shareholders. While many may choose to ignore these warning signs and others might fail to understand them, hopefully in future you will at least be better placed to factor them in to your investment decisions.
Conclusion
Negative net asset value, or negative shareholders' equity, does not automatically signal imminent insolvency or financial distress. The underlying reasons for the negative equity are critical and must be carefully evaluated.
If the negative equity stems from excessive debt financing or poor capital allocation, it becomes a cause for concern.
However, the market's perception of the company's future growth potential and ability to create value can sometimes outweigh the significance of negative equity. Investors may choose to ignore it if they believe the company has a strong business model and promising growth prospects.
In essence, negative shareholders' equity is not inherently a red flag. A more comprehensive analysis of the company's financial position, asset composition, and growth outlook is needed to accurately assess its financial health and solvency. It's essential to avoid making simplistic judgments based solely on the balance sheet.
Great article, on the 'Net Net's' it is where Net current assets less all liabilities exceeds the market cap. Not just Net assets. Net assets exceeding market cap is very common, a huge percentage of companies are like this particularly in Europe.