A company’s worth consists of the value of its operations, plus the value of any non-operating assets, such as excess cash or unused real estate. Most public companies do not hold significant excess assets. Ranks of activist investors stand ready to force companies to invest excess capital productively or else return it to shareholders.

But what about the exceptions? I know of several unlisted companies that hold cash and securities worth much more than their actual operations. How should these companies be valued by investors? The answer depends on who’s asking.

The value of a company’s excess assets is highest to an acquirer. When the acquisition closes, the acquirer gains complete control over the excess assets and is free to use them in any way. For an acquirer, excess assets are effectively a dollar-for-dollar discount to the acquisition price.

For everyone else, the story changes. Owning a minority stake in a company does not entitle one to determine the use of excess assets or otherwise exercise control. Investors must accept the risk that excess assets will either languish on the balance sheet for years to come or even be squandered on ill-conceived projects or acquisitions.

Because a minority investor has no control over the disposition of excess assets, the value of these assets should be discounted. Yet, so many investors do not. I routinely see investors making statements like this:

“I think Company Z is worth 10x its operating income of $15 million, or $150 million. Plus its excess cash of $20 million for a total value of $170 million.”

Well sure, if that $20 million is available to you. But try calling up the CEO and asking for your proportional share. You won’t get far. So how is an investor to treat excess assets? I argue for a “behavioral” approach, based on how a company has historically treated the excess capital it generates. Let me use an example.

OPT Sciences Corp. manufactures anti-glare and other specialized glass products used to cover instrument panels in aircraft. The company’s products are used in the Boeing 777 and 737, as well as Gulfstream and Dassault jets. OPT Sciences has fashioned a very nice business in this niche. EBITDA margins have averaged 18.2% over the last five years, and net income and free cash flow have been positive in every year since 2003.

For the twelve trailing months ended April 27, 2013, OPT Sciences recorded $1.25 million in operating income, or $1.61 per share. Weighing its consistent record against its limited growth prospects, an investor might assign a value to OPT Sciences’ operations of 6-8x operating profit, or $9.66 to $12.88 per share.

Since this blog post is about valuing excess assets, it should be no surprise that OPT Sciences happens to be massively overcapitalized. At quarter’s end, the company held $10.62 million in cash and securities against zero debt. Even assuming the company requires cash balances of 10% of annual sales to operate, excess cash and securities amounts to $12.81 per share. The company’s share price mid-point is $16.13.

At this point, many investors would conclude OPT Sciences is worth $22.47-$25.69, based on the value of its operations and excess capital. And it may be, to an acquirer. But it is likely not to you, or to any other minority owner, because it may be many, many years before that excess capital is put to productive use.

OPT Sciences has little opportunity for growth investments, yet is unwilling to return excess capital to shareholders. The company has paid only one dividend in recent history, a measly $0.65 payment in December 2012. OPT Sciences is 66% owned by a trust that benefits the children of Arthur J. Kania, a businessman from Scranton, Pennsylvania. Because paying significant dividends would trigger tax consequences for the trust, it is unlikely that the company will make meaningful distributions in the near future. And because the trust owns 2/3 of shares outstanding, no outside investor can force the company to disgorge excess cash. Any would-be investor in OPT Sciences must be willing to purchase a large, unproductive heap of cash and securities alongside the attractive operating business.

Because the company’s excess assets are completely unavailable to investors and will likely remain so, the excess assets are not worth their market value. But they’re clearly still worth something. After all, the trust could be dissolved or the company could be sold or the company could change course and declare a series of special dividends. Determining the fair value of the company’s excess assets is a matter of estimating the likelihood and timing of these possible favorable outcomes. Below are some example scenarios, followed by the present value of the company’s excess capital under each, assuming a 12% discount rate.

Scenario 1 – Business as usual. Every five years the company pays a $1.00 special dividend, and is sold in 20 years for a price that includes the full value of its excess capital. In the meantime, the excess capital appreciates at 3.5% after-tax. Likelihood: 50%.

Scenario 2 – Mr. Kania (who is 81) passes in ten years and the company is sold for a price that includes the full value of its excess capital. In the meantime, the excess capital appreciates at 3.5% after-tax. Likelihood: 35%.

Scenario 3 – The company decides to distribute excess capital to shareholders in equal installments over five years, and continues as a going concern thereafter. Likelihood: 15%.

The present value of the firm’s excess capital is lowest under scenario one.

Because the full amount of the excess capital is not received for 20 years, its present value is only $3.36 per share. The longer a company fails to invest excess capital productively or distribute it to shareholders, the less valuable the excess capital is.

Scenario 2 is somewhat better.

Cutting the time it takes to receive full value for the company’s excess capital to 10 years nearly doubles the present value of the excess capital.

Scenario 3 is by far the best for shareholders.

Receiving all excess capital in equal installments over five years yields a present value of $10.23.

Recalling the various probabilities I assigned to each scenario, the probability-weighted present value of the company’s excess assets is $5.32. Adding this figure to the $9.66-$12.88 range of values I assigned to the company’s operations results in a total value of $14.98-$18.20, neatly bracketing the company’s actual trading price. (I swear I did not work backwards.) Clearly, investors are following some process by which they are heavily discounting the value of OPT Sciences’s excess assets.

The scenarios I used are completely arbitrary and are intended only to illustrate the process. A more complete set of scenarios might include one where the company is acquired within a short time, as well as one where the company squanders the excess assets completely.

No matter how exactly they choose to do it, the point is that minority investors should carefully consider how and when they are likely to benefit from a company’s excess assets. Company ownership structure matters, as does a company’s historical capital allocation policy and current management’s intentions.

What seems like a very under-valued company may not be.

The one significant exception is a scenario where a company is capable of managing non-operating assets to produce a return that exceeds its cost of capital. For example, imagine a wholly equity-financed company with a cost of capital of 9%. If the company has a portfolio of stocks and is capable of earning an after-tax return of 9% on them, that company is doing just fine by its shareholders. However, if the company can only earn 6% after tax, it is better off divesting the funds and sticking to its core operations. The second scenario is far more common, as most management teams lack the talent to manage both their core operations and an investment portfolio.

No position in OPT Sciences Corp.