Much of billionaire investor Warren Buffett's early success came from investing in companies whose shares traded at a discount to the value of their assets. This traditional value investing technique can deliver impressive profits, but care is required. When companies trade below book value, it's often for a good reason.
Today I'm looking at two companies trading at big discounts to their book value. Is either stock a genuine bargain?
A property turnaround?
Ei Group (LSE: EIG) is probably still better known as pub chain Enterprise Inns. The company recently changed its name, as it's aiming to move away from operating tied pubs to become a commercial property landlord.
However, the reality is that this business is still dominated by an enormous debt hangover from before the financial crisis. The group has net debt of £2.17bn, backed by £3.58bn of property assets. That's equivalent to a loan-to-value ratio of 60%, which is high for a commercial property firm.
Subtracting net debt from the value of the property portfolio gives a net asset value of £1.45bn. Ordinarily, Ei's market value should be somewhere close to this figure. But at the time of writing, the firm's market cap is just £645m. This means that at 135p, the shares trade at a 55% discount to their book value of 300p.
If this discount eventually closes, then buying these shares could be very profitable. But it's not clear to me how likely this is. The group generated an impressive £269m of operating cash flow last year, but £155m of this was used for interest payments and £70m was spent on refurbishing pubs.
So far, debt reduction has mostly been funded by pub sales. If this situation continues, then the stock's low valuation may be justified. I'd want to do more research before considering whether to buy.
This bank could be cheap
Challenger banks such as Virgin Money Holdings (LSE: VM) have been a profitable investment over the last few years. But Virgin Money has lost 15% of its value over the last 12 months, even as competitors soared ahead.
What's gone wrong? Well, it may be nothing. But investors have become concerned about the credit card market, an area where Virgin has delivered rapid growth. The bank's credit card balances have risen from £1.5bn to £2.7bn in the last 15 months, and it's targeting £3bn by the end of 2017.
Much of this growth has been driven by offering interest-free periods of up to 41 months. Banks record profits from credit card customers during these interest-free periods, on the assumption that customers will start paying interest at a later date. So credit card growth has been making a nice contribution to Virgin's profits, even though many customers aren't paying any interest.
The risk is that instead of staying loyal, customers nearing the end of their interest-free period will simply transfer their balance to another provider offering interest-free lending. If this happens, credit card issuers such as Virgin could be forced into significant profit writedowns.
The bank's shares currently trade at a 28% discount to net asset value, with a forecast P/E of 7.8 for 2017. This may seem cheap, but the prospective dividend yield is just 2.1% and the situation looks uncertain to me. I think there's better value elsewhere.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.