The balance sheet
tells you about the assets and liabilities of the company at some
point of time. It can also show how it has changed over a period of
time. You should evaluate it critically. Graham says you should
accept the company´s figures about liabilities. The real value of
the assets can be different than company has announced. The value of
some fixed assets, such as inventories are not always the same as
found from the balance sheet. Some of them can have the same value
company paid for them even though they are worthless. Intangible
assets such as, mental capital of the employees and brand value are
hard to evaluate. They can be either much undervalued or overvalued.
Most often they are overvalued. You have to use your own judgment
about the worth of such assets.
As an analyst, you
will benefit at least in four ways. First, you can define the
character and the amount of the resources that are used in a
business. These resources are the basis of the earnings in the
economically survivable business. A business without proper resources
cannot have any significant earnings in a competitive industry. You
can also use the balance sheet to find out how much an owner of a
business can get from the liquidation of the company´s assets, when
the business is not survivable.
Second, you can
also use the resources in the balance sheet to figure out the
character and stability of the company´s sources of income. Graham
thought that the return of assets can only seldom create more income
than the cost of capital. He believed that earnings estimates that
are only supported by the balance sheet are realistic and accurate
enough. The earnings of the business are short-lived unless the
balance sheet support them. Graham believed that bigger profit
margins were tempting for new competitors without a need for a strong
balance sheet.
Third, the
liabilities tell an analyst about the sources of financing and
economical situation. The large amount of recurring debt or
nonrecurring debt that needs to be paid in few years refers to coming
financial problems. Even small variations can lead to a significant
losses of enterprise value. Fourth, the changes in the balance sheet
tells you about the quality of the earnings.
Cash flows should
reflect on the changes in economic situations in the companies. You
have to remember that balance sheet tells you the situation about the
assets and liabilities right now. Without following the changes in
the balance sheet, you cannot evaluate the development of the
business and how it should happen in the future.
You can make an
estimation about the value of the balance sheet in many ways. Graham
had three different ways of doing it. He used a book value, a quick
ratio, and current ratio. Graham defined a book value by adding all
the fixed assets together and subtracts them with all the
liabilities, preferred stocks, and their liabilities. Quick ratio
adds up the cash and cash equivalents, and divide them with all the
liabilities and preferred stocks. Cash includes all the marketable
securities, etc. Current ratio adds up all the current assets and
divides them with current liabilities.
Graham had mixed
attitudes toward the book value during his investment career. He
first ignored the book value in a book Security Analysis, because he
thought that companies reported flawed estimated about the values of
the assets in the balance sheet. On the other hand, he uses book
values later in his career, when he was trying to find right
securities for his diversified portfolio. He also believed that you
should check the book value if you are interested about the stock of
a company and want to make an estimation how much you should pay for
it. You should never take a company´s valuation by itself. You have
to know Quick ratio for a stock is seldom larger than how much you
have to pay for it in the markets. These situations can be valuable
for the investor, unless a company has large losses.
I hope you will
find time to search through a balance sheet of a company for the last
business cycle. You should find out how assets and liabilities have
progressed through the cycle. Then make your own conclusions about
them. For example find out if they have any discontinuities? If so,
why?
-TT
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