Reading Financial Statements: Canexus Edition

July 11th, 2012 by Potato

There’s something of an art when it come to reading financial statements as an investor: a lot of things are open to interpretation in how you value them, and your own valuation may not necessarily agree with that of the accountants who prepared the statement.

A great example was brought up recently by SBrunner. She runs a very strange site, where she provides all kinds of data on a company, almost entirely free of commentary. Just spreadsheets and facts. Recently she highlighted one of my favourite companies (and largest holdings), Canexus. Though she doesn’t explicitly say that she disapproved of the change in Nexen’s ownership, she did prominently highlight the large drop in “book value” that happened at the time.

The thing is, the transaction had no effect on the true book value. It was all just an accounting shadow play.

Consider a case where I own 1/3 of some tangible thing, and my friend Netbug owns the other 2/3. I can choose to subdivide my ownership of the thing into 100 shares and then sell those shares on the stock market. Each share is ownership of 1/100 of 1/3 of the thing. If we put a value on this tangible thing, say $100,000, then each share is worth $333.33 in this example.

Now let’s suppose that Netbug wants to raise a bit of cash, but doesn’t want to sell his entire stake in our shared mysterious thing. He converts his ownership into shares that are identical to the ones I created: he creates 200 shares, so each is still worth 1/100 of 1/3 of the underlying thing (or if you prefer unsimplified fractions, 1/200 of 2/3). He could then sell those shares into the stock market (where they would not necessarily trade for the underlying value of $333.33/share).

This is a bit of a complicated transaction, and would greatly increase the float… but at the end of the day, the book value of each share didn’t change: the thing that we own is still the same, and each share still represents the same fractional ownership of this thing.

Well, that’s pretty much exactly what happened with the “buy out” in Canexus: Nexen converted it’s 2/3 ownership of the underlying business into shares, and dumped those shares on the market. Yet SBrunner reports a massive decrease in book value associated with the transaction. If one were to judge that and add some commentary, you might say that it represented massive dilution, or may have been a poor takeover, or something to that effect… if it indeed were a take-over and if book value had in fact changed.

So what happened? SBrunner, for the record, didn’t get it wrong: the book value according to the financial statements did drop by a massive amount. If you look to the balance sheet statements before and after the transaction, divide by the number of shares, you get the values she reports. She’s just faithfully tracking what the accountants are saying.

The problem was with the way book value was reported in the statements. For some reason, when the shares represented a minority ownership, the book value was calculated in a way that did not involve taking the net of the assets-liabilities and dividing by the ownership stake. In other words, the books of Canexus before Nexen spun off their stake did not simply represent 1/3 of the underlying operating business. There was this line item for the value of the ownership stake, and it got in there at the level it did by some accounting wizardry. From what I can tell, goodwill without calling it goodwill.

It was fine for the auditors, and probably made sense to the tax people, but as an investor, why would you have used that number as your figure for book value, instead of taking 1/3 of the value of the underlying business? If you had calculated book value yourself using that method (and the statements for the underlying operating company were reported in the same annual reports, just a few pages further in), then the transaction of releasing more shares from the previously non-trading part of the ownership didn’t affect your personal sense of how the company should be valued at all. If you relied on the way the statements were prepared, then suddenly there was this massive shift in value under your feet, simply because of how the accountants reported the worth of a minority stake versus the whole pie consolidated together.

So this is one real-world case where you may need to come up with your own interpretation of the financial statements, rather than relying on what the accountants have prepared according to GAAP/IFRS.

One Response to “Reading Financial Statements: Canexus Edition”

  1. Netbug Says:

    Sweet! I hypothetically own a portion of some tangible hypothetical thing!!! I like this game!