Business development companies (BDCs) carry tax advantages that make them attractive investments for income investors. One way to determine whether a BDC's stock price makes it a good bargain is to look at its net asset value, or NAV. Many investors are familiar with net asset value in the mutual fund context, and the concept of NAV with business development companies is similar. However, there are some important aspects to net asset value with BDCs that differ from funds, and it's important for BDC investors to understand them fully. Below, we'll look more closely at net asset value of business development companies.
What net asset value means for BDCs
The idea of net asset value for BDCs is simple to understand. To calculate NAV, start by valuing all of the assets that the business development company owns. Then subtract any liabilities on its balance sheet. The resulting difference is the total net asset value. Investors typically look at NAV on a per-share basis, so take the difference between assets and liabilities and then divide it by the number of BDC shares outstanding.
To understand how this works, take a typical example. Say that a BDC has assets worth $350 million and has debt and other liabilities totaling $150 million. The total net asset value would be $200 million, and if the BDC has 10 million shares outstanding, then the resulting NAV per share would be $20.
Why NAV works differently for BDCs than for mutual funds
Mutual fund investors are used to net asset value being extremely important in how a particular fund works. With most mutual funds, the NAV is calculated once every day, and investors are allowed to pay the corresponding NAV amount to purchase new shares or receive that NAV amount if they sell shares. Put another way, net asset value is something that mutual funds use in their operations all the time.
By contrast, business development companies don't buy and sell shares of their own stock. Instead, they offer shares on the public exchanges, and supply and demand among buyers and sellers of BDC shares determine their ultimate price on the open market. Investors can and do take net asset value into account in evaluating whether a given BDC is a good value, but it doesn't have to bear any direct relationship to the share price at any given time. Typically, some BDCs trade at premiums to their NAV, while others trade at discounts. All other things being equal, investors should prefer to buy BDC shares at prices below net asset value rather than paying a premium.
What a discount to NAV can mean for BDCs
One thing that's extremely important for BDCs, however, is that their ability to raise capital is limited if their share price is less than their net asset value. Ordinarily, BDCs can issue secondary offerings of stock at any time if their shares trade at a premium to NAV. When there's a discount, however, shareholders must vote to approve the offering because of the dilutive impact of selling new shares at a price below the net asset value of the fund.
It's also important to understand that a BDC that trades at a discount to its net asset value could reflect concerns about the BDC's management or asset quality. In particular, high management fees can siphon assets away from the BDC, having a downward impact on NAV over time.
If you want to invest in business development companies, knowing the net asset value is vital. Comparing NAV to share prices can give you insight into how current investors think about the BDC and its future prospects.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.