“the balance sheet deserves more attention than Wall Street has been willing to accord it for many years past” Benjamin Graham, Security Analysis
This statement is just as true today as it was when Ben Graham wrote it in 1934. When an investment is going well, understanding the balance sheet seems unimportant. But when things go wrong, investors often look back at what happened and ask themselves “why wasn’t I paying attention to the balance sheet?”
If the earnings represent the output of a company then the balance sheet represents the resources that are utilized by the company in order to generate that output. To look at a company only in terms of what it’s capable of producing is to understand only half the story. To use an analogy, I know my car is capable of achieving a speed 70 mph for long periods of time – this output has been regularly achieved by my car over the last 5 years. But what enables the car to continuously do this? It’s a combination of the engine, the chassis and the wheels – i.e. the resources of the car. I may have driven for 5 years quite comfortably at 70mph, but if the engine is in poor condition I could break down by the side of the road tomorrow. It pays therefore to take a look under the hood once in a while. I tend to study the balance sheet for one of three reasons – as a valuation tool, as a financial health check and as a warning system.
The Balance Sheet as a Valuation Tool
The book value admittedly has limited use as a valuation tool. For fixed assets, the book value is based on historical cost, depreciated over time to reflect the decline in its useful life. While in some cases this is not a bad approximation of the current value, in other cases the market value can deviate quite drastically from the book value. The sophisticated analyst of course has the option to collect their own data – use industry sources to find market values or replacement values. Analysts who cover the industrial or resource sectors will sometimes compare price to replacement cost as an alternative to looking at book value.
The second issue with book value is probably a more serious one – that it fails to adequately capture a whole range of intangible assets. Again from Benjamin Graham:
“under modern conditions the so-called ‘intangibles’ e.g. goodwill or even a highly efficient organization, are every whit as real from a dollar-and-cent standpoint as are buildings and machinery”
Accounting has come some way since the 1930s, but it still struggles to capture all the intangible assets on a company’s balance sheet. Brand recognition, customer relationships, trained workers and patents are all resources of the company, but they are not represented on the balance sheet.
Despite these issues, the balance sheet is not completely redundant as a valuation tool. Because book value tends to underestimate the true value of the company’s resources, a price to book of less than one is an interesting data point in itself. Where the price to book value is very high, it may be because the stock is expensive, or it may be because the balance sheet has not captured the true value of the company’s resources. A comparison to book will never serve a definitive valuation tool, but it does provide a starting point for further work.
The Balance Sheet as a Health Check
While the book value of assets are unreliable, the book value of liabilities tend to be absolute – for the most part these represent a dollar figure that is owed by the company to creditors. Investors should therefore pay particular attention to companies that have a high level of debt relative to equity and/or earnings.
Beyond the size of the debt burden, the maturity profile is also important to consider. Where a large portion of debt is falling due in the next 12 months, the risks are particularly heightened.
“A large bond issue coming due in a short time constitutes a critical financial problem when operating results are unfavorable…Even when the maturing debt can probably be taken care of in some way, the possible cost of the refinancing must be taken into account” Benjamin Graham, Security Analysis
The Balance Sheet as a Warning System
Changes in the balance sheet over time are a valuable indicator of stress. Like a knocking sound coming from your car engine, these shouldn’t be ignored.
Simple things like changes in working capital ratios can signify trouble and deserve your attention. Monitoring days of inventory, days of sales outstanding and days payable will usually deliver valuable insights. For example an unexpected increase in days payable might signify financial strain. An increase in days of inventory might point to manufacturing issues.
In other cases, stress is represented by broader changes in the balance sheet. Over the course of 2000, Net Property Plant and Equipment at WorldCom increased by a massive 27% – a huge amount for a large company like this. After the company went bankrupt it was revealed that part of this increase was down to fraudulently capitalizing operating expense. In 2001, long-term debt at WorldCom increased by $12.5 billion in 2001, even as another $1bn of debt was deconsolidated via a subsidiary. For any analyst paying attention to the balance sheet, these were all signs that something wasn’t right at WorldCom.
Next time you feel you’re cruising along without any worries, make sure you take some time to check under the hood. As many famous investors have themselves discovered, monitoring the balance sheet can help you to avoid the costly mistakes that seem so obvious with hindsight.
Tom Beevers is the CEO and Cofounder of StockViews, a marketplace that connects professional investors with independent analysts. Further educational material on analyzing a balance sheet can be found at the StockViews Campus. If you know you’re way around a balance sheet, you might want to consider applying for the role of analyst here.