NAV (Net Asset Value)

Refers to a fund's total assets less its liabilities.

The net value of the company's assets is less its liabilities. It is often the case that the net asset value is close to or equal to the book value of a business. Companies considered to have high growth prospects are traditionally valued more than NAV might suggest.

NAV net asset value

In some cases, the discounted cash flow (DCF) model cannot be used as it assumes the company's perpetual growth. However, this isn't the case with these models; hence energy companies (which can't assume perpetual growth because of limited natural assets) use them.

Here is the calculation formula:

Net Asset Value = (Value of Assets - Value of Liabilities) ÷ Total Share Outstanding

Note a denominator consisting of total shares outstanding; this is because companies often need to compare NAV per share for investment purposes.

The usage of this is mostly for mutual funds and unit investment trusts-UITs, especially the open-ended ones; it allows for issuing an unlimited number of shares. However, it is used in other sectors, such as Real Estate, oil, and reserve companies. 

Speaking of NAV in a mutual fund, issuance and redemption of shares are decided using NAV. If a person suddenly invests a fixed certain amount of money in the fund, his share in the fund is calculated using the present value of the NAV of the fund.

Mutual funds

Even many oil and gas investors use these NAV models to project cash flows, estimate the weighted average cost of capital, and analyze different business segments.

It is also useful for mutual fund calculations. To find a mutual fund's NAV, take assets less its liabilities and divide by the total number of shares.

To understand the calculation, here is an example:

Suppose there is an investment company with securities and other assets worth $100 million and liabilities of $10 million; the investment company's value will be $90 million.

Since the value of NAV will change daily depending on assets and liabilities, Mutual funds and Unit Investment Trusts calculate their values every business day after the exchange closes.

in Mutual funds

We can observe that the calculation is very sensitive concerning assets and liabilities considered.

Understanding

Hence, we need to strictly follow the definition of Asset and Liability given below:

Asset

A mutual fund's assets include the market value of the investments, cash reserves, cash equivalents, and other income.

These are included in various forms, such as a percentage of capital in the form of liquid assets and cash and other items like interest payments, dividends, etc.

Liability

The liabilities include outstanding payments, money owed to the lenders, and other fees owed to associated entities. 

Apart from these, mutual funds also have foreign liabilities, including shares for non-residents, pending payments to foreign conglomerates, and various sale proceeds that are yet to be ousted. 

Liability

It also includes various accrued expenses, including utilities, staff salaries, operating expenses, distribution, management, expenses, etc.

Let us try to understand the role of net asset value in a fund's performance. 

The first and foremost statement is that net asset values and funds' future performance are not correlated. It merely illustrates how the underlying assets have performed in the previous years. 

There is a chance that the NAV is low for a fund, but it doesn't mean it will be a lucrative investment. We need to check its historical performance and its returns.

Hence, investors shouldn't make it a deciding parameter while choosing funds for investment. They should check the returns from their investments to make an informed decision. Net value is useful to understand how a fund performs every day. 

That is, investors need to compare the present and past values of funds to calculate their rating.

More on NAV

Interpretation

Though it represents the share price, it doesn't change with the share price. It is updated and adjusted at the end of the day.

Interpretation

Now, as we value a fund using NAV, the price of the fund at which it can be bought is fixed; hence, the number of shares in the fund is changed, not the price. 

As we all know, per share is slightly different from the share price, so it is proportional to the value of the securities in the fund. 

Used in Decision-Making

The most common analysis error in NAV is people try to compare two mutual funds to understand which outperformed and which underperformed. Now, each fund will have a different set of companies. Each company's stock price might not indicate its growth potential. 

Hence, assuming that the NAV will give a direct idea of investments is not great. NAV gives absolute values, and there is no scope for direct comparison.

To determine which fund performs better, we must look at various parameters. We need to look at each fund's performance history and the securities and benchmark the fund with an appropriate index.

Advantages

  1. It reduces the calculation complexity as all the assets are valued separately and added later.
  2. It also provides a valuation after liquidation, hence providing maximum downside risk.
  3. Since the calculation of assets is separate, this helps us understand the tangible assets and the risk of loan default.

Advantages

Disadvantages

The principles of accounting change from region to region, which changes the financial statements in the following ways:

A. It doesn't show the company's future earnings; it only depicts the current position of the company. 

B. A company's value can be very high if the assets are disposed-off item by item.

In Real Estate

It is one of the valuation indices of real estate investment trusts (REITs). It is an adjusted value reflecting the market values of real estate properties held by an investment corporation. 

Unlike tech companies, where intangible assets account for the vast majority of the asset values, in real estate, tangible assets account for the valuation; hence we use the net asset value model. 

The degree of premium/discount on individual investment unit prices relative to the per-unit value serves as a yardstick for assessment. 

Real estate

The index is synonymous with the price-to-book ratio in which factors such as unrealized losses/gains of owned properties and brand values are reflected. 

It can be provided to investors as a share value, depending on the investment structure. The discount on REITs depends on the cap rates. The lower the cap rates, the higher the discount. 

Discount or premium also depends on the sector of real estate. Valuation multiples are also used apart from Modeling REITs. 

Some sectors that trade at a premium are healthcare, industrial parksdata centers, etc. The sectors that trade at discounts include malls, offices, hotels, etc. 

Various parameters affect the net value of assets in real estate. So let us have a look at those.

Net Operating Income

NOI is the total revenue generated by a property minus its operating expenses. Since there is a change in the property-level change in supply and demand, there is an impact on renters' ability and willingness to pay for the property. 

This can be due to an increase in the number of properties nearby offering lower prices to the customers or the addition of new job opportunities nearby, leading to an increase in demand.

As we saw above, NOI is very price-sensitive; however, this isn't the case with this unless the changes remain steady/continue for a longer period. 

Capital Market Changes. 

Capital markets have the greatest impact on NAV. In real estate, annual property income only accounts for 10-20% of the total return; the remaining 80%-90% is driven by the "capped NOI" or the residual value of the property. 

Capital market changes

Since the cap rate acts as a net operating income multiplies when supply or demand changes that affect entire asset classes become permanent, these changes impact implied growth and exit cap rates and therefore have the greatest impact on net asset values.

Valuations of REITs are one of the most challenging tasks in financial modeling. Let us have a look at challenges in net asset value:

  1. The most important thing to consider is identifying/deriving cash flow, and improper derivation leads to a bad valuation.
  2. Valuation of assets that don't generate income.
  3. Finding a cap rate(rate of return) requires extensive market research.

How Net Asset Value is different from Discounted Cash Flow model

The difference is:

  1. A Net Asset Value model assumes that the company never increases its existing reserves, so there is no additional CapEx in future years beyond what is required to develop existing reserves. 
  2. The other difference is in the order calculations are done. In the case of the net asset value model, the value of all the assets is evaluated separately and added. In contrast, in the case of discounted cash flow, all the calculations occur simultaneously.

In discounted cash flow model, the intrinsic value is the present value of the future cash flows of a business discounted back at an appropriate rate.

DCF model

However, with the net asset value, the thought process is the company will undergo a shortage of resources and might have to stop its business. 

For evaluating non-perpetual growth companies with limited resources, we assume that no new resources will be generated. This way, how much profit will the company be able to generate?

Metrics like revenue growth or EBITDA margins do not apply to Oil and Gas companies' valuation.

There are three types of reserves used in calculating the Net Asset Value model:

1P: Proved Reserves

2P: Proved + Probable Reserves

3P: Proved + Probable + Possible Reserves

Proved reserves

It is defined as the number of energy sources estimated to be recoverable from well-established or known reservoirs with the existing equipment and under the existing operating conditions. 

A reserve is considered proven if it is probable that at least 90% of the resource is recoverable by economically profitable means(economically accessible). Also known as Measured deposits.

Probable reserves

Probable reserves are those additional reserves that analysis of geoscience and engineering data indicate are less likely to be recovered than proved reserves but more certain to be recovered than possible reserves.

When we consider probability for a more refined definition, there are two ways to look at it. We need a probability of 50 percent that the acquired quantities will be greater than the 2P estimate. 

This can also be seen as the probability that the reserve can be found in more than 50 percent. These are technically accessible but not economically. They are also known as Indicative deposits.

Possible reserves

This is included in 3P calculations for reserve estimation. Similar to probable reserves, this also looks at finding reserves in two ways. 

Probable reserves

In this case, the probability of finding the reserves greater than or equal to the amount according to 3P is greater than 10 percent, or the probability of finding reserves is greater than 10 percent in that given area. 

They are accessible neither technically nor economically. They are also known as Assumed deposits.

To get all these parameters, we use the PV10 calculation. Let us understand the PV10 model.
We saw above various types of reserves that are used in the calculation; now, to get an idea of how they are converted to financial statements, we use PV10. 

PV10 is the value of oil and reserve companies. It is calculated to find the future net revenue and is calculated taking into consideration only Proved reserves. The discounted rate usually takes around 10 percent. 

This again gives rise to the Discounted Cash Flow model(cash flow is calculated for the time the reserves or oil will get depleted). Now since it is difficult to estimate the value of reserves in the future, the PV10 doesn't give an accurate estimate.

PV10, not being accurate in the absolute term, is one of the most accurate for oil and reserve companies. The valuation of an oil and reserve company is one of the most difficult for investors to understand and evaluate.

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Researched and authored by Punit Manjani | LinkedIn

Reviewed and Edited by Aditya Salunek I LinkedIn

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