"Lynch Rebates"

Most people today who write about value investing emphasize discounted cash flow valuations and various other techniques that rely on projections of future earnings or cash flow in determining the intrinsic value of a stock.

That's fine. But if you read the beginning of Graham and Dodd's 1940 edition of Security Analysis you find that Graham's entire argument for asset-based investing is that projection of current earnings trends into the future is inherently an unreliable exercise. Anticipating today's behavioral economists, Graham understood far better than most (with the help of being bankrupted by the Great Depression) that we as investors are not nearly as accurate in predicting the future as we think we are.

To fight this bias, Graham argued for investment in stocks that had share prices trading at less than two-thirds of their net current asset value. Buying cheaply in this sense, or at any other deep discount to readily ascertainable corporate value, meant that an investor didn't have to predict anything to make money.

Many extremely literal readers of Graham and Dodd (we could call these "value fundamentalists") took this advice to mean that investors must only buy Graham's "net-nets." So they sat around through the second half of the twentieth century with their hands in their pockets as the population of always-rare net-nets thinned out further and further.

Peter Lynch introduced a brilliant solution to this problem in One Up on Wall Street, a book that is far too often caricatured as a simplistic "buy what you know" manifesto. Lynch's technique is to take the net cash of a company--that is, cash on the books net of long-term debt, and apply that figure to the share price as a "rebate" of sorts.

Here's an example of how this works . . .

Take 4Kids Entertainment (NYSE:KDE), which licenses the rights to use Pokemon and several other children's entertainment franchises that may or may not have value.

The stock closed today at $16.85. According to the most recent balance sheet, the company has 105.64 million of cash and liquid short-term investments, along with no long-term debt. For the sake of simplicity, this is assuming that there are no substantial lease obligations or other obligations that are not readily ascertainable from the balance sheet. That gives us a figure of about $9 a share in cash or assets readily convertible to cash.

So you subtract that $9 from the share price of $16.85, leaving you an effective share price of $7.85, since you're getting paid 9 bucks to hold each share. So you're buying the business at about a 53% discount.

You then compare that $7.85 to the value of each share of the business to see whether the business is worth that discounted price. I don't know if the business at 4Kids is attractive at that price, but it's clear that it's considerably more attractive than it would appear without getting this sort of discount.

In my experience, this technique is a terrific way to find businesses at extremely attractive values.

Disclosure: I do not own shares of KDE.