What’s The Deal With Negative Shareholder Equity?

Are you tossing and turning at night worrying about negative shareholder equity?  Does this accounting anomaly fill your thoughts, robbing you of a good night sleep?  Does your significant other turn to you and say in a sultry bedroom voice, “Oh darling, tell me about the negative shareholder equity again…”

No, probably not. (Unless accounting puts him or her to sleep)

If your an investing nerd like me however, negative shareholder equity is an investing topic that’s fascinating… yet very much ignored by the investing press.

Why?

Probably because it’s a weird accounting artifact, and the general public could care less about accounting…

What Is Negative Shareholder Equity?

When you invest in a stock, you’re actually buying that company’s assets — The buildings, the inventory, the contracts and the bank accounts.  It’s not just a piece of paper!  Along with those assets, you’re also getting the liabilities — the debts, the accounts payable, taxes payable, and all other forms of liability.

It’s a balanced package and the difference between the two is shareholder equity:

Assets – Liabilities = Shareholder Equity

Most of the time in a healthy company, shareholder equity will be a positive number.  Perhaps the company earns cash and then puts that cash in a bank account, piling onto the asset side of the balance sheet.  But because it’s balanced, this also means we have to add the same amount to Retained Earnings in Shareholder Equity

Assets (+$$) = Shareholder Equity (+$$) + Liabilities

Or, perhaps the company uses the cash they earn to pay down debt.  This lowers the liabilities side of the balance sheet and ensures positive shareholder equity.

Liabilities (+$$) = Assets – Shareholder Equity (+$$)

Either way you swing it, the balance sheet remains balanced, with shareholder equity essentially “filling-in” the difference.

Now, some of the time it can happen that shareholder equity turns negative — when the company’s Liabilities become larger than its Assets.

Why Does Negative Shareholder Equity Happen?

When shareholder equity turns negative, frequently this is a sign of trouble.  Generally you see negative equity most often when there are accrued losses that sit on the balance sheet.

If the stock has had several years of unprofitability it builds up in a balance sheet category called ‘Retained Earnings’.  Only in this case, losses subtract from retained earnings (losses are negative).

Since shareholder equity is typical a combination of retained earnings and the capital used to fund the business in the first place (often called ‘Additional Paid-in Capital’) it might take awhile before a company becomes truly insolvent.

Accrued losses are one way negative shareholder equity happens, but not the only one.  There’s other ways it happens too — such as assets being re-valued at prices dramatically lower than what they were originally purchased at.

Most of these events are largely negative.

As an investor who wants to own good quality companies, I’m more interested in special cases where negative shareholder equity is the sign of a really wonderful company.

Investing In Good Companies With Negative Shareholder Equity

Under conventional definitions of “a wonderful company”, most investors would point to quickly rising sales and growing profits, not negative shareholder equity.  These same investors might also point to growth stocks like Facebook (FB), Google (GOOG), or Netflix (NFLX) and say, “Look at how fast they’re growing!”

Yes, they’re growing quickly, but it’s very likely these companies are also wasting shareholder money.  The examples — Facebook, Netflix, and Google plow nearly cent they’ve ever earned back into the business.

Growth companies often waste incredible amounts of money on speculative projects that never pay off (Google Glass anyone?)  Or, they purchase companies that may never earn enough to justify the overly  high purchase price.  (Facebook buying Oculus might be a good example).

Unfortunately most investors only care about growth.  It’s a very rare investor that understands there’s more to investing than just sales growth at any cost.

What if you could get growth almost for free? — without plowing a whole bunch of money into the business every year?  When a company can grow without the continual need for reinvesting fresh cash, it’s a wonderful business indeed.

Yes, these companies do exist!  Instead of wasting shareholder cash, they frequently pay large dividends and buy back stock, retaining very little to reinvest.  Every year they do this and still continue to grow.

This is where negative shareholder equity comes into play — Since the purchased shares are effectively canceled, this means there’s fewer shares outstanding and the remaining shareholders have a larger piece of the pie.

What happens to the balance sheet over time is kinda funny — A share buyback shows-up in the shareholder equity section of the balance sheet as a line item called “Treasury Stock”.

Total Shareholder Equity = Common Stock + Preferred Stock + Retained Earnings + Additional Paid in Capital + Treasury Stock

Treasury stock is typically a negative number that represents how much money was spent on share buybacks.

But here’s the thing — shares of good companies tend to appreciate over time.  So the company may effectively spend more money on share buybacks than they ever received as part of their IPO (represented by Additional Paid-in Capital).

If the company buys back enough shares, eventually shareholder equity turns negative.  It’s an impressive feat, typically achieved by only the best businesses.  It’s the “good version” of negative shareholder equity.

Moody’s Corporation (Stock Symbol: MCO) is my poster child for this “good version” of negative shareholder equity.

While GAAP accounting says that Moody’s is “a worthless company”, with negative shareholder equity, that’s far from the actual truth.  Moody’s has little need to retain earnings and the business is so good that sales continue to grow despite not put money back into the business.  Instead, they buy back a ton of shares.

This is incredible, and speaks to what a great businesses Moody’s is.  It grows without adding new money into to it!

Other good companies that exhibit negative shareholder equity include: McDonalds (MCD), Phillip Morris International (PM), Limited Brands (LB), and Colgate Palmolive (CL).

These are companies that focus on doing the right thing with shareholder earnings — nearly all of them sport impressive returns on assets (ROA).  Meaning, for every dollar of earnings that they do retain they aren’t wasting it.

The Finish Line

Negative shareholder equity is this funny accounting thing most people could care less about, but I think it’s a very instructive indicator that something unusual is going on with a stock.  Companies that exhibit this behavior might be worth investigating further.

Negative shareholder equity is also important for investors to learn about because it unlocks some really important lessons for investors — Such as the importance of returns on capital.

All empires rise and fall.  It’s the nature of well… nature (and the stock market).  The stock market provides outsized rewards to growth stocks, but eventually even these large empires crumble.

Were those corporate empires good stewards of capital?  Did they provide a good return to shareholders?

These questions are far too complicated to answer here in just one post, but I will leave you today with one investing lesson that’s been around for ages….

Dinosaurs once ruled the Earth.  These giant lizards were extremely large and consumed vast amounts of resources due to their shear size.  Then, a black swan event happened (probably a meteor), which wiped the dinosaurs out.

Food and resources became scarce.  Only the smaller beasts survived; those that made effective use of much smaller quantities of resources.

Perhaps one day the growth companies of today will need to survive on much less too.

[Image Credit: Flickr1, Flickr2]