Security Analysis Part VI: Balance-Sheet Analysis. Implications of Asset Values
Introduction
There are four fundamental areas of usefulness from the balance sheet:
- The quantity and nature of resources employed in the business
- Provides a basis for analyzing the nature and stability of sources of income.
- The liabilities describe the financial condition of the business.
- The evolution of the balance sheet provides a check on earnings quality and financial stability.
Beyond this, balance sheet analysis can lead to the discovery of investment bargains. Historically at some points in time the market has focused almost exclusively on the earning power of a business in order to determine prices. In contrast, logically, the value of a business should be the larger of its discounted earning power and its liquidation value. If the liquidation value is substantially above the market value then there is very little risk for the investor and the potential of substantial gain, even assuming a negative earnings outcome.
Book Value vs. Current Asset Value
Generally, book value is looked upon as a rough estimate of the liquidation value of a business. This is generally a poor choice. Book value is simply an accounting convention that shows about how much money has been put into the business and should be understood as this. In contrast current asset-value is much closer to the true value for an investor.
The first rule in calculating current asset value is that assets should be questioned and discounted, while liabilities are real. Different assets should be valued at different discounts. Generally cash and marketable securities can be valued at very close to 100% of their market value. Real Estate, which is generally carried below actual value, should be considered above book value if appropriate. In contrast inventory should be discounted to 70%-50% of the book value.
Opportunities and Perils of Net-Nets
Companies selling substantially below liquidity value are generally very good investments. A situation like this should never really occur, and is a testament to the strange relationship between shareholders and their employees (i.e. management). Generally, stock holders have abdicated most of their rights to management, under the notion that management has superior knowledge and abilities regarding the business.
There are three main perils in net-nets:
- Poor management causes continual losses, eating into the asset value.
- Time to liquidation or market re-appraisal is lengthy and the IRR ends up being mediocre.
- Time to liquidation is long and the existing assets drop in value (i.e. securities drop in market selloff).
Given this the best opportunities arise when there seems to be a catalyst that will realize the value. Examples of this are:
- Strategic Acquision’s
- Management discussing a liquidation
- Potential for the recovery of earnings power
A fourth possibility, if you are a large enough investor, is to purchase a controlling share and force the liquidation over the short term (i.e. activism).
Relative Cheapness
Relative cheapness should not generally be a criterion for investment (in contrast to absolute cheapness). When market downturns happen almost all stocks are hit equally hard. In contrast, when stocks in general are cheap, the potential increases of leading stocks may prove larger than those for the cheapest companies.
Financial Impairment
Much balance sheet analysis has focused on determining whether there is enough value on the balance sheet to justify a value higher than the market price. This chapter will focus on the more common analysis of identifying financial weakness that may impair the merits of an issue. Even the best of businesses can go bankrupt if they do not have an adequate balance sheet to survive the inevitable rough seas of the economic ocean.
For cyclical companies be careful if large debt payments are set to occur close to each other, especially if there is any reason to believe that period may coincide with the negative part of the cycle. This may particularly be the case if companies use intermediate debt to finance operations during a cycle upswing and is the most dangerous. For the repayment of short-term debt it is generally known where the funds will come from (i.e. accounts receivable, orders, etc.) at the time the debt is subscribed. Long-term debt will generally be paid if the business is viable and will not otherwise. Intermediate-term debt on the other hand can cause the bankruptcy of a great business if the timing is unlucky.
When looking at financial impairment, losses such as those originating from write-downs or selling inventory at a loss are not as dangerous as those which need to be financed.
