Net-Net: Definition, How It Works, Formula To Calculate
James Chen, CMT is an expert trader, investment adviser, and global market strategist.
Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).
What Is Net-Net?
Net-net is a value investing technique developed by the economist Benjamin Graham, in which a company’s stock is valued based solely on its net current assets per share (NCAVPS). Net-net investing thus focuses on current assets, taking cash and cash equivalents at full value, then reducing accounts receivable for doubtful accounts, and reducing inventories to liquidation values. Net-net value is calculated by deducting total liabilities from the adjusted current assets.
Net-net should not be confused with a double net lease, which is a commercial rental agreement where the tenant is responsible for both property taxes and premiums for insuring the property.
Key Takeaways
- The net-net value investing strategy was developed by Benjamin Graham using net current asset value per share (NCAVPS) as the primary measure to evaluate the merits of a stock.
- According to the net-net strategy, the ability to generate revenue from current assets is the true value proposition of a business.
- Current assets, which are used in the net-net approach, are defined as assets that are cash, and assets that are converted into cash within 12 months, including accounts receivable and inventory.
- The net-net investing strategy does not consider long-term assets or liabilities, making it unreliable for long-term investments according to its critics.
Understanding Net-Net Investing
Graham used this method at a time when financial information was not as readily available, and net-nets were more accepted as a company valuation model. When a viable company is identified as a net-net, the analysis focused only on the firm’s current assets and liabilities, without taking other tangible assets or long-term liabilities into account. Advances in financial data collection now allow analysts to quickly access a firm’s entire set of financial statements, ratios, and other benchmarks.
Essentially, investing in a net-net was a safe play in the short term because its current assets were worth more than its market price. In a sense, the long-term growth potential and any value from long-term assets are free to an investor in a net-net. Net-net stocks will usually be reassessed by the market and priced closer to their true value in the short term. Long term, however, net-net stocks can be problematic.
The formula for net current asset value per share (NCAVPS) is:
According to Graham, investors will benefit greatly if they invest in companies whose stock prices are no more than 67% of their NCAV per share. And, in fact, a study done by the State University of New York showed that from the period of 1970 to 1983 an investor could have earned an average return of 29.4% by purchasing stocks that fulfilled Graham’s requirement and holding them for one year.
However, Graham made it clear that not all stocks chosen using the NCAVPS formula would have strong returns, and that investors should also diversify their holdings when using this strategy. Graham recommended holding at least 30 stocks.
Special Considerations
Current assets, which are used in the net-net approach, are defined as assets that are cash, and assets that are converted into cash within 12 months, including accounts receivable and inventory. As a business sells inventory and customers submit payments, the firm reduces inventory levels and receivables. This ability to collect cash is the true value of a business, according to the net-net approach.
Current assets are reduced by current liabilities, such as accounts payable, to calculate net current assets. Long-term assets and liabilities are excluded from this analysis, which only focuses on cash that the firm can generate within the next 12 months.
Criticisms of Net-Net
The reason net-net stocks may not be a great long-term investment is simply because management teams rarely choose to fully liquidate the company at the first sign of trouble. In the short term, a net-net stock may make up the gap between current assets and market cap. However, over the long term, an incompetent management team or a flawed business model can ruin a balance sheet quite rapidly.
So a net-net stock may find itself in that position because the market has already identified long-term issues that will negatively affect that stock. For example, the rise of Amazon.com has pushed various retailers into net-net positions over time and some investors have profited in the short term. In the long term, however, many of those same stocks have gone under or been acquired at a discount.
The net-net strategy of finding companies with a market value below its net-net working capital (NNWC)—cash and short-term investments + 75% of accounts receivable + 50% of inventory — total liabilities—may be an effective strategy for small investors. Net-net companies are sought after by day traders which may contribute to their rise in month-to-month valuation.
What is a Net-Net stock and why it’s so attractive?
The (imaginary) shoe company “The Green Shoe” has managed to increase its sales and profits every year, and its shares price has increased accordingly. And then, surprisingly, its largest customer, consisting approximately 60% of its sales, announced that he is switching to a competitor. The investors panicked and dropped the share in dozens of percents. At that exact point, Benjamin Graham would have noticed the stock.
Graham, the father of value investing, was the first to understand the direct link between a company’s financial results and value of its assets, to the price at which the company’s shares should be traded. Graham was especially fond of company’s shares such as our imaginary “The Green Shoe” company, whose prices were too low, even lower than its Tangible Asset Value.
To those who are not familiar with accounting, we will tell that a company has assets and liabilities. The liabilities are the company’s way to receive external funding for its activity and they include the debt to banks and investors (by bonds), payments to suppliers, payments to the IRS etc. These funding are used to purchases assets. These consist of current assets, i.e. assets that are already cash or are expected to turn into cash in the next 12 months, and long-term assets that the company has no intention to sell, such as property, plants, and equipment.
In principle, the company can decide to close its operations, sell all its assets and return all its liabilities using the money received from them. What is left of the assets can be distributed to investors as dividends. So, as it may seem, it does not make sense that the Company’s market capitalization will be lower than this value. However, most companies do not want to stop working at the moment, and in addition, cannot easily sell the assets at the value shown in the balance sheet. For these reasons, there is a possibility that the value will be lower than the difference between total assets and liabilities.
Once realizing this issue, Graham looked for extreme cases where the difference between current assets alone to all the liabilities, was higher than the company’s market value. Graham was even more conservative and did not take into account all current assets. He summed only cash, 75% of account receivables (the amount of money that has not yet been paid by customers who have purchased products from the Company), and half the value of the inventory that has not yet been sold. Moreover, Graham demanded that the market capitalization of the company will be 33% lower than this net current asset value, what he called “Net-Net Value”. In other words, he looked for companies with effective net-cash that is much higher than their market capitalization. Purchase of shares at such a low valuation means that we actually get long-term assets (property, plants, and equipment) for free. These assets are worth a lot of money so this suggests a temporary valuation distortion.
And what happens to these companies? At a worst case scenario, these companies do not manage their problems, they continue wasting cash, and sometimes shut down their operations. In this case, the stock may of course lose its value, but in a limited manner since it is already quite cheap. However, in most cases, Net-Net companies are acquired by one of their larger competitors, mostly in a significant premium above their asset value, or they return to a positive economic activity. In both scenarios, the stock goes up dramatically.
In order to deal with the uncertainty and profit from the investment, Graham held simultaneously a large number of Net-Net shares, and sold them one year after buying. As expected, most of the Net-Net shares prices rose, and this strategy yielded a phenomenal yearly average return of 29.4% in the years in which he used it. Many other studies over the years have strengthened the evidence that Net-Net shares are expected to beat the market.
A Net-Net stock that I bought 6 months ago and recently “jumped” dramatically is Echelon Corporation (ELON). The stock was traded at $4.1 and jumped 100% in one day as Adesto Technologies, a leading provider of innovative application-specific semiconductors for the IoT era, announce its intention to acquire Echelon for $8.50 per share. In the future, I’ll add a page containing all Net-Net stocks in the leading Stock Exchanges in the world so you can use them to spice your portfolios.
Net Price & List Price: What is the Difference?
This is the whole (maximum) sum that a customer will pay for an item before any discounts. Hence, a list price is the highest possible price for the end buyer. This price depends on two major factors:
- The prime cost of producing an item or developing a service for your business;
- The average price of that product’s or service’s analogs on the market.
Many businesses try to follow the list price when introducing a new item or entering the market because it’s intended to help them establish and maintain profitability.
However, sticking to list prices is the right strategy only if you sell one-of-a-kind items (which allows you to enjoy a monopoly on the market) or the value of your product/service is so great that customers don’t expect any discount. Average retailers rarely stick to this approach because competition is very high. Luxury brands, on the contrary, are known for offering the list price only.
Anyway, the market keeps growing in all industries and new options are introduced every day. Hence, no brand, even a well-known one, can keep ignoring competitors’ offers and customers’ behavior. Any strategy should be adapted properly, and net price plays an important role here.
Net price is the cost of a service or product after promotions and discounts. This is what attracts customers and drives sales. Discounts and promotions are widely used when introducing a new product or as a part of a seasonal marketing offer.
Why is net price important? The profit margin largely depends on a company’s price management. The difference between list price and net price defines whether the company is ready to be a serious competitor and make profit naturally, or it needs to apply more effort and build its reputation among business partners and customers.
Sticking to the list price seems to be the best scenario, but the truth is that the modern market is highly competitive, especially when it comes to eCommerce. Competitors can easily set a more appealing price and perform much better for customers. Sometimes, setting an optimal net price is the only option to increase sales.
However, it’s important to remember that discounts should not greatly affect your profit margin. A perfect pricing strategy is about achieving a balance between attracting customers and financial stability.
Here are the basic principles of calculating the most reasonable net price:
- Calculate the cost and overhead of manufacturing the product (or developing the service).
- Figure out the expected profit from your sales — the list price should help with that.
- Subtract all discounts that you plan to use (wholesale, loyalty discounts, seasonal offers, etc.).
- Consider all taxes and fees (legal, transportation, installation) that may influence the price.
Say you want to sell a smartphone and calculate a list price of $1,000. To motivate your customers to buy it, you decide to offer a 10% discount. That means that with a list price of $1,000, the net price will be $900 since you subtracted $100 as a discount. Depending on your end buyer, this net price can be different because you offer larger or smaller discounts. A wholesale dealer may want a bigger discount than a customer you sell to directly.
The most optimal price depends on the level of competition in your market. If you have few rivals, you can prefer setting the list price instead of a discounted net price. But such markets are rare, so most likely, you will need to stick to the net price to stay competitive.
To find a well-balanced price, you should keep the following in mind:
- Figure out cost-plus pricing. Consider the entire cost of the production and development, and set a desired profit to calculate the list price.
- Research the market and your competitors. That will help you understand how serious the competition is, and craft a pricing strategy that doesn’t give other companies an opportunity to come with a better offer.
- Build relationships with distributors. Proper communication allows you to negotiate fair net prices and get mutually beneficial discounts.
- Learn about your customers. That will help you understand how much they are willing to pay and which price works better for you both.
Introducing discounts on the list price allows a company to boost sales volume, create loyalty among customers and engage more potential buyers. You can run seasonal promo campaigns, create a discount program for loyal clients, and offer post-sale discounts for future purchases.
Price fluctuations also help to sharpen your competitive edge. For example, when a key competitor starts sticking to a list price and offers it to more price-sensitive customers, you can reduce your prices to generate more demand for your product.
To implement this strategy, you need a top-notch price monitoring tool, ideally one that displays both current and historical prices. Priceva’s Price Tracker can help you analyze the cost of products and build a solid pricing strategy to outperform your competitors.
Price management mostly depends on the level of competitiveness, production costs, and demand for the product.
The list price shows the highest profit rate because it is based solely on your company’s interests, but the net price is a more efficient competitive tool when there are many analogs around, or your business has just entered the market. Buyers are often looking for reasonable prices, so discounts and promotions work well for attracting an audience.
From a technical standpoint, a lower price is the only thing you can offer to your customers when there are many analogs. All other variables, such as production cost and legal obligations (taxes, fees) cannot be customized to help you achieve the desired profit margin.
Hence, it is important to use the net price of a product properly and come up with discounts that will be appealing for customers while keeping your earnings high enough. When you enter a highly competitive market (and most of them are full of alternatives), other companies can simply undercut you by offering lower prices. At the same time, keeping your prices minimal means you don’t have space to experiment.
Net-Net
Net-net is a term used for a company with a market capitalization that is less than the difference between the company’s current assets and total liabilities. The equation does not consider long-term assets, such as property, plant, and equipment (PP&E), and intangibles.
Net-net investing is used with the underlying understanding that if the net-net (company) is sold, the current assets would be used to settle the obligations or liabilities, and the leftover amount (cash) will be worth more than the market capitalization of the company. In other words, the stock price is below the net current asset value (NCAV) of the company.
What is the Net Current Asset Value (NCAV)?
Net current asset value (NCAV) is the value of the current assets minus total liabilities, including preferred shares and off-balance sheet liabilities. NCAV is derived when you remove the long-term assets component from total assets, leaving a highly conservative estimate for a company’s value in case of liquidation. The NCAV strategy and net-net investing was founded in the 1930s by Benjamin Graham and was thought of as a good proxy to gauge a company’s real-world solvency value.
Price to NCAV of an Investment
A related concept is a multiple involving NCAV. P/NCAV can help investors and analysts determine whether a stock is under or overvalued. A low P/NCAV means the stock is undervalued. A company can alter its NCAV by buying back or issuing common shares.
Net-Net Investing: The Warren Buffet Perspective
The net-net strategy was used by Warren Buffet to grow his investments. He popularly referred to this as the “cigar-butt” investing technique. The strategy was taken from Graham, and Buffet came up with a simple rule to buy a stock. He said that if the stock price is less than 2/3 of the difference of the current assets and total liabilities, it is a net-net stock. The equation is given below:
Buffet stated that the only rule of thumb was the equation, and one does not need to analyze the company’s financial statements, conduct fundamental analysis, or make any qualitative or quantitative judgments. The strategy was a bit controversial, as most of the stocks trading as net-net stocks are not very sought after, and people avoid them as they are trading at ridiculously low prices. Moreover, people are scared to invest in companies that may undergo bankruptcy (although, there are instances of profit generation in such cases, too).
Success of Net-Net Investing Strategy
It is interesting to see that despite net-net being such a volatile strategy, the strategy yields positive returns. There are several factors as to why the net-net strategy is considered successful, including:
1. Riskiness of stocks
Looking at market data for a basket of net-net stocks, the stocks tend to show a beta (volatility) greater than 1, indicating that any movement in the markets will cause a larger impact on the change in the stock price of the stocks (indicating why such stocks might’ve historically outperformed relative to other average stocks).
2. Market liquidity
If a company’s stock is selling below its NVAC, it is normally a small company with illiquid stock. As the stock is hard to buy/sell, it will take time for the investor to react to any news that comes regarding the stock. Therefore, for such stocks, investors get a higher premium to compensate for the illiquid risk they are being exposed to.
3. Long-term reversal
A common concept in trading is that everything will eventually revert to the mean, and if anything’s previously been performing badly, it will perform well now. Studies indicate that net-net stocks performing well could be because they were not doing too well earlier (although this argument may seem flawed and biased).
4. Financial distress
Any company that is showing liquidity or solvency problems tends to garner a negative reaction from the market. The negative reaction often leads to the stock price falling way below the fair market price (making the company undervalued and, therefore, a potentially attractive investment).
Pitfalls of the Net-Net Investing Strategy
The net-net strategy comes with certain pitfalls, as not everyone can benefit from it. The investing technique does not always work, with certain investors demonstrating months of underperformance when employing the strategy. The strategy tends to do well if used for a longer time horizon (based on the success factors mentioned in the earlier section).
Another problem of the strategy arises if investors do not diversify and focus on one to two stocks to do the work. It is possible that not every net-net stock posts the gains expected, so it is very important to diversify and invest in a basket of net-net stocks. The net-net strategy works well for illiquid stocks, and as most investors are unable to purchase shares due to the thinly traded volume, they end up not benefitting from the strategy.
Related Readings
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: