This doesn’t work all the time.
But if a stock makes it through the initial checklist, and then the framework below, you’re 90% of the way towards figuring out what you have.
Scenario 1: Profitable Liquidations
Is the Enterprise Value more than the replacement cost of the company’s assets? If the answer is no …
- Is book value — minus any impairments, liquidation costs and market capitalization — greater than zero?
- Is the liquidation value growing, stable or shrinking?
- Is the company about to be liquidated?
- Is there an opportunity for someone else to come in and force a liquidation? What’s the catalyst to eventually make the stock price move higher?
Scenario 2: Earnings Power Analysis
Is the Enterprise Value more than the replacement cost of the company’s assets? If the answer is no …
- Is book value — minus any impairments, liquidation costs and market capitalization — greater than zero?
- Earnings Yield: Is Normalized EBIT/Enterprise Value greater than 10%?
- Return on Capital: Is Normalized EBIT/Capital Employed greater than 10%
- Are above-average returns on capital sustainable?
- Can capital be reinvested at the normalized return on capital?
You’re not ready to start buying once you have the answers to the questions above. But you can quickly eliminate a lot of duds and gather enough information to ask the right questions about the potential investments you have remaining.
