What goes down, must come up! Investigating companies with negative book value
Have you ever imagined book value going negative? Book value reflects the accounting value of a company to its ordinary shareholders and can only be negative if the company’s liabilities exceed its assets. Given publicly-traded companies’ limited liability structure, a shareholder’s payoff function would resemble that of a call option holder on the assets of the company with a strike price equal to the nominal value of its debt. In other words, theoretically, the shareholder’s value should be strictly non-negative. Therefore, the fact that companies with negative book value are sometimes omitted by both academic and practitioners alike should come as no surprise to well-versed market participants.
Nevertheless, if we consider value premium to be derived from a company’s distress risk, then the expected returns of the companies with negative book value should be disproportionally higher than their positive book value counterparts.
In this white paper, we attempted to study the historical performance of US companies with negative book value relative to the broader US equities, as well as to identify the factors that drive the performance of companies with negative book value.
Highlights in this White Paper:
Within the universe of companies that had reported negative book value at least once between November 30, 1998, and April 30, 2019, we observed that:
- Approximately 55% of the companies subsequently reported positive book value within one year after declaring negative book value.
- Companies with smaller market capitalization outperformed those with larger market capitalization.
- Companies with higher ability to manage short-term obligations, as measured by the current ratio (defined as current assets / current liabilities), outperformed those with lower ability.
- A periodically rebalanced strategy comprising of smaller stocks with higher current ratio generated an annualized excess total return of 4.9% over the broader US equities.