The Graham and Dodd School of investment philosophy stressed the importance of balance sheet analysis and their value investing methodology, and this has proven to be a safer investment option than other methodologies. Value investing involves buying securities that are under-priced when compared to their intrinsic value. Benjamin Graham, who is regarded as the father of value investing, established the NCAV strategy to find deep values. Dubbed as the "Net Current Asset Value" or "Net-Nets" methodology, NCAV is calculated by subtracting all liabilities from the current assets on a per share basis.
Graham looked for companies with market valuations at about 66% of the net-net value. He gave himself at least a 33% a margin of safety to fall back on. Net-nets are much rarer today than they were when Benjamin Graham wrote the early editions of "Security Analysis" and must be approached with caution and researched with vigor; calculating the Piotroski F-score and the Altman Z-Score (a tool to predict likelihood of bankruptcy) are critical to ensure that you are not buying a company soon to become bankrupt if you are using this strategy. Graham employed this methodology with a solid understanding of the company’s balance sheet and financial health.
Warren Buffet stated that the intrinsic value of a stock can be calculated by calculating the future cash flow of the company and discounting it to the present. Calculating the intrinsic value can pose a challenge since there are different methodologies to value a stock and one can come up with entirely different conclusions regarding the intrinsic value of the company based upon different assumptions in their Discounted Cash Flow (DCF) model. I wrote about the strengths and weaknesses of DCF here (http://www.gurufocus.com/news/145102/the-strengths-and-weaknesses-of-dcf). It is necessary investors do a thorough study of the balance sheet before making stock purchase decisions based upon DCF, and Buffett has done the same by requiring that companies have strong underlying business economics as one of his four filters for selecting stocks. I do not waste my time with DCF until I do a financial health check-up based upon a balance-sheet analysis.
There are several key metrics that can be calculated from the balance sheet that will give the investor insights into the financial health of the company.
The current ratio is the calculation that enables one to determine the company’s ability to pay its short-term debt obligations. It is obtained by dividing the current assets by the current liabilities of the company. As a rule of thumb, a ratio below one indicates that the company may not be able to pay its debts while a ratio above one indicates that the company is capable of paying back its debts and is hence financially healthy. It depends on industry and company.
Quick-assets ratio or acid test ratio is a liquidity indicator that measures the amount of liquid current assets that are available to cover current liabilities. To obtain this ratio, cash and equivalents is added to the sum of short-term investments and accounts receivable and then divided by current liabilities. A higher ratio indicates more liquidity.
The cash ratio is a further refinement of quick ratio as well as current ratio that indicates a company’s liquidity that measures cash, cash equivalents or invested funds in the current assets to cover the current liabilities. Understandably, this ratio is the most stringent and conservative of the three short-term liquidity ratios.
The debt ratios are similarly important in the study of financial health of a company. It includes ratios like debt-equity ratios, debt ratios, capitalization ratio etc.
Debt ratio is used to compare a company’s total debt to its total assets and is obtained by dividing total liabilities of the company by its total assets. A low percentage indicates that the company is less dependent on leverage, which is the money borrowed or owed to others. A lower ratio, therefore, means a stronger equity position.
Debt to equity ratio is instrumental in providing information on how well a company is leveraged to meet its financial obligations and its financial stability. It indicates the proportion of equity and debt to finance the company’s assets. The higher the number, the greater is the debt burdening the company and vice-versa.
Capitalization ratio is obtained by dividing long-term debt by the sum of long-term debt and shareholder’s equity. This ratio is considered to be more meaningful of the "debt ratios" since it gives one an insight into the company’s use of leverage. A low level of debt and healthy proportion of equity is an indication of a financially healthy company. The lower the ratio, the more financially fit the company is considered.
Interest coverage ratio determines how easy it is for a company to pay interest expenses on the outstanding debt. It is the ratio of earnings before interest and taxes to the interest expense. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet the interest expenses is highly questionable.
Certain profitability indicator ratios, such as return on assets, return on equity, return on capital employed, and effective tax rate are also a significant help in understanding the asset performance of any company.
Effective tax rate is the measurement of a company’s tax rate which is obtained by dividing income tax expense by pre-tax income. The variance of this ratio percentage tends to have material effect on the net income figure.
Return on Assets (ROA) ratio is considered as a profitability ratio as it shows how much a company is earning on its total assets. It can be calculated by dividing net income by the company’s total assets. This ratio can also be viewed as an indicator of asset performance. A high return implies that a company is performing well and managing its assets commendably. There are other financial ratios that can be helpful in finding out if a company has rock-solid balance sheet and is not prone to any financial illness.
Return on Equity (ROE) ratio is a measurement of company’s profit and is obtained by dividing the net income by average shareholder’s equity. This ratio indicates the shareholder’s earnings for their investment in the company.
Value investors can also make use of Piotroski F-score which is quite helpful in identifying the healthiest of the companies among other value stocks by applying a set of nine accounting-based criteria for stock selection. David Brickwell wrote an excellent article on the topic here. One point is awarded for each criterion that the stock passes. According to Piotroski, any stock that scores eight or nine is in strong financial health. He also found that weak stocks that scored only two points or less had a 500% increased risk of going bankrupt or being de-listed because of financial problems.
To calculate the Piotroski F-score, one needs to give a score point of one for every criterion mentioned below that a company fulfills.
A. Profitability Signals
1. Net Income is positive in the current year.
2. Operating Cash Flow is positive in the current year.
3. Return on Assets is higher in the current period compared to the previous year.
4. The cash flow from operations exceeds net income.
B. Leverage, Liquidity and Source of Funds
5. There is a lower ratio of long term debt in the current period when compared to the value in the previous year.
6. Higher current ratio in the current year compared to the previous year.
7. The Firm did not issue new shares/equity in the preceding year.
C. Operating Efficiency
8. Higher gross margin when compared to the previous year.
9. Higher asset turnover ratio year on year (as a measure of productivity).
Researchers have shown that this method has proved quite useful as an effective value filter, and it is critical for analyzing distressed companies.
A company’s financial statement also reflects the current book value of its assets, which is determined by its acquisition or historical cost less any depreciation. Replacement costs provide an alternative method in valuing a company’s assets. This is the amount of money that is required to replace the asset by purchasing an asset with identical service capabilities. When an acquiring company is trying to obtain a company’s value before making a purchase offer, replacement costs have proved a more accurate measure rather than the present book values of the assets. This is because it takes into account factors like inflation that accurately reflect current economic conditions, which can have a hand in affecting the value of the company’s assets.
You don’t have to be a financial professional to understand financial statements or to purchase your own stocks but you do need to understand the basics of financial statements if you are going to manage your own stock portfolio. For a great resource for investors without a finance background, I suggest reading Richard Loth’s "Select Winning Stocks Using Financial Statements." Utilizing the methods described above can go a long way in enabling a value investor to make informed and well-balanced investment decisions. However, it is only an early step on the path to selecting stocks as the value investor must also understand the company’s competitive position, profitability, stability of earnings, management stewardship and intrinsic valuation.
About the author:Margin of Safety Equity Research is a value-investing focused company providing equity research services, the Securities Analysis System investment software, stock valuation models, and other financial resources for value investors. Members of our subscription services have access to the Margin of Safety value-oriented portfolio and discounted access to our software.
We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:
1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins
2. We understand the business
3. They are run by competent management
4. They are available at bargain prices.
We require a 25-50% margin of safety, depending on the stability and economic moat for the company.
In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.