The original article was written by Josh Klein.
Noise constantly bombards the market. As value investors, it's our job to shift through all the noise and focus on investment analysis that reveals everything we need to know about a potential opportunity.
Surprisingly, not even index investors can avoid this problem.
Let us venture then into the world of investment analyses and delve into everything you need to know about the essentials of breaking down a company's balance sheet to determine its financial health.
So, what kinds of noise will we find when exploring investment opportunities? Some of it -- such as company reports and press releases – is good noise. This type of noise contributes positively to an investor’s backlog of information needed to make sound investment decisions. On the contrary, other noise – such as market predictions and trend analyses – has no tangible benefit. It clouds judgement and turns otherwise wise investors into impatient short-term traders. The only constant in the unpredictable markets is sound investment research and valuation. This article will discuss different types of investment analyses: everything you need to know.
Investors have the luxury of approaching special situations or deep value investing in many different ways. A group of investors can look at a particular industry or cluster of companies from different angles and end up finding the same undervalued securities. Patience, conviction, and a deep understanding of the anatomy of a company – i.e. its financial statements – are all one needs to beat the grueling beast we call the market.
Let us venture into the world of good investment analysis and delve into the essentials of breaking down a company’s balance sheet to determine its financial health.
Investment Analyses: Everything You Need To Know About Balance Sheet Ratios
Analyzing the balance sheet is a fantastic way to value a company. We generally look at companies as going concerns and value them based off their ability to generate earnings and free cash flow into the future, although we also can analyze them in an asset-based approach. Truly understanding the balance sheet will help you sift through the garbage and determine which companies are healthy with potential upside.
Investment Analyses: Everything You Need To Know About Book Value
The best way to analyze a balance sheet is to start broad — and only after move to more specific ratios. Naturally, the first step in one’s analysis should be the price to book ratio (P/B). Because the P/B ratio takes into account the entire balance sheet, it is a great way to start investment analyses. To calculate the P/B ratio, one needs to subtract the total liabilities from the total assets. To determine the book value per share, the result should be divided by the total amount of shares outstanding. The P/B ratio can also be calculated by taking the owner’s equity number found on the balance sheet – which is the same as all assets less total liabilities – and divide that figure by the total shares outstanding.
As an example: If a company has $20 million in cash, $80 million in inventory, $100 million in property, plant, and equipment, $50 million in accounts payable, $100 million in long term debt, and 10 million shares outstanding, what would the company’s P/B ratio be?
On the asset side, the company owns $200 million worth of cash, inventory, and property (20 million + 80 million + 100 million). This can be used to sell goods, make further investments, or used as collateral for future business activity. On the liability side, the company owes $150 million (100 million + 50 million). The company must ensure it can pay the $150 million to its creditors and vendors. Based on the values provided, the equity in this company would be $50 million – or the difference between the $200 million assets and $150 million liabilities. Thus, the book value per share would be $50 million divided by the 10 million shares outstanding – or $5 per share. If the company’s stock traded below $5 (i.e., with a price to book ratio of less than 1) or it traded at a ratio less than its peer companies trade relative to their book values, the stock could potentially be undervalued.
Although companies usually state inventory and equipment at the lesser of cost or market to ensure they don’t overstate their financials, the book value doesn’t always depict an accurate picture of the company’s asset health. In the event the company is insolvent or needs to make quick cash for investment purposes, seldom are they able to liquidate their assets at 100% of cost. So, how does one avoid this uncertainty and ensure one’s investment analysis doesn’t overstep true asset value? Net current asset value (NCAV) is the answer.
Investment Analyses: Everything You Need To Know About Net Current Asset Value Ratios
In order to discount the excess value accredited to certain items on the balance sheet, one can look at the NCAV of a company instead. The NCAV excludes assets that aren’t convertible into cash – such as goodwill and other intangibles – and discounts long-term assets entirely. Although many long-term assets such as property and plant have value that can be liquidated in the event of a bankruptcy, it is often difficult to determine how much of that value is salvageable.
For instance, if an oil refinery goes out of business, there are only so many ways one can reposition that plant to other uses. A competing refinery will either have to purchase the property, or it will have to be scrapped out to other companies that could use its pieces for their respective businesses. Due to this unfortunate circumstance, the bankrupt company will have to sell the property at a significant discount.
Utilize NCAV as an investment analysis tactic to avoid the large discrepancy between stated value and realized value for these long-term assets. One calculates the current assets – cash, marketable securities, inventory, and all other assets likely to turn into cash within a year – and subtracts all liabilities, current and long-term alike. Although non-current assets might be overstated on the balance sheet, long-term liabilities always represent 100% of the stated value.
If a company’s share price trades below its net current asset value, it could potentially be undervalued. Essentially, purchasing $1 of the stock would be cushioned by at least $1 of the company’s NCAV. Therefore, the rest of the business’s operations and future cash flows would be bought for free. Unfortunately, in our example above, the company has a negative NCAV of –$50 million ($20 million cash + $80 million inventory - $50 million accounts payable - $100 million long-term debt). Although the company might be undervalued based on its P/B ratio, it wouldn’t be based on its P/NCAV ratio.
However, there are a few issues that emerge with NCAV, or net-net, investing. Calculating a company’s net asset value includes inventory in the mix. In the event of a bankruptcy, it is highly unlikely the company will be able to sell 100% of the inventory stated on the balance sheet. Think of some retailers that have recently gone bankrupt – Toys R Us, Nine West, and Radio Shack. Due to economic constraints and debt difficulties, these retailers were forced to close down shop. But what happens to all of the toys, clothing, or gadgets that are left unsold on the shelves? What about the thousands of replacements or out-of-fashion items sitting in warehouses collecting dust? These items are put up for sale and turned into cash as quickly as possible to pay off creditors. Rarely do these oversubscribed or out-of-fashion goods get sold at cost. For that exact reason, distressed debt investors will likely include a 10%-30% discount (depending on the industry) to the value of inventory.
Conclusion
Our title "Investment Analyses: Everything You Need To Know" is a bit loaded. Special situation and deep value investors constantly find new ways to analyze balance sheets to sift the markets for opportunities. This list isn’t meant to be exhaustive. There are other ways to find value in the market; however, these three strategies – purchasing stocks either below their book value, NCAV, or cash value – have proven to work for decades. Adhere to these tactics and see the returns slowly follow suit.
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