Understanding the phenomenon of market capitalisation being lower than net assets

Market capitalisation (Market Cap) is the market view of the value of a listed company’s equity (owners’ stake) derived from the price of its trading stock. For example, the market cap of CompanyX will equal the total number of issued shares in the company multiplied by the stock price as observed on the Uganda Stock Exchange(USE), assuming the company is listed.

This implies that, assuming all the shares of Company X are floated on the USE, then the ownership of the company can exchange hands priced at the market cap through trading on the USE on that very day. Another view of the value of an entity is its net assets value (NAV), that is, its total assets minus total liabilities. Assuming the entity is healthy (not impaired and a going concern), the market cap should ideally be greater or equal to the NAV at that date.

However, the above is not always the case. In may instances the level of liquidity in a certain stock market will have a significant bearing on how stocks are priced because the pricing of stocks is aligned to the laws of demand and supply. For illiquid markets like the USE, it is not uncommon to find market caps being lower than NAVs for listed entities. Even in liquid markets, its possible to find the same scenario and this sometimes is triggered by perceptions within the trading market arising out of negative publicity regarding the trading company, opaqueness in the operations of an entity, or negative events occurring in the sector of the entity, etc all of which can impact on the level of demand and consequently on the listed price on any particular day, even when the revenue potential of the entity itself is not affected.

Therefore, it is possible that Company X, although its market cap is lower than its NAV, might be impaired or not under the circumstances. This phenomenon is just a red flag. It might be possible that the revenue/cash potential of the entity has been inhibited possibly because of factors internal and/or external to the business.

As such it is always prudent and recommended by the International Financial Reporting Standards (IFRS), to explore a more scientific estimation of the net realisable value (NRV) of the company’s equity which should normally be the higher of the company’s value-in-use determined from its revenue/cash potential and it’s market capitalisation. If the NRV of the entity is still lower than its NAV, then the conclusion is that the entity is impaired, and the extent of this is estimated by the difference between the NAV and NRV.

If the entity is impaired, then the reported/book value of the entity’s goodwill (if any) should be reduced by the quantum of the impairment assessed, and whatever remains of this is overlaid on the other cash generating assets of the entity. If there is no impairment, only a disclosure regarding the state of market cap is required according to IFRS.

The computation of the NRV needs to be done appropriately, because the resultant conclusions could potentially guide or mislead the entity’s stakeholders about the business model and operating environment of the entity. It is prudent to have this assessment reviewed by a professional business valuer, who can also provide insights into the matters affecting the business and resolutions.

There are several indicators of impairment that should trigger impairment assessments – the phenomenon of market cap being lower than net assets is one of them.

Page 1 of 9 results