A recent Financial Times article entitled “Volkswagen falls to biggest annual loss in its history,” highlighted the following points:
- Volkswagen has reported the biggest annual loss in its 79-year history, as the growing cost of provisions for its emissions testing scandal pushed the carmaker further into the red.
- For 2015, the German carmaker reported a net loss of €1.6 billion — its first loss since 1993. A year previously, it had achieved a net profit of €10.8 billion.
Browsing through these highlights may indicate that Volkswagen is an easy pass for an investment. On the other hand, reviewing the company’s financial statements may be worth the use of some brain cells.
Volkswagen brands and products
Source: Company’s website
Volkswagen’s business requires high manufacturing costs to operate, such as production of quality cars and maintenance of daily operations; in addition, the company also provides its own financing to its customers. Therefore, maintaining a certain level of financial performance, especially balance sheet strength, over the long-term is critical for the company to survive.
Strength of balance sheet
Reviewing Volkswagen’s ability to meet its financial obligations would reveal whether or not the company has the capacity to do so, or whether Volkswagen would require more debt, or possibly issue more shares to fund its ongoing operations. This assessment can be done through checking the company’s current and quick ratios.
Current and quick ratio
The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and illiquid) relative to that company’s current total liabilities.
Benjamin Graham, father of value investing, would often select good companies with current ratios of more than 2.
Quick ratio, on the other hand, can be solved by excluding inventory assets in the current assets resulting into a more conservative ratio value. Nevertheless, both ratios appear to be hovering at or above 1 in the recent 10 quarters.
Debt numbers
Volkswagen demonstrated a steady amount of debt in the recent quarters. This steadiness was also reflected in its debt to equity ratio. A ratio of less than 0.5 or at least a declining ratio would be attractive to a conservative investor. A declining ratio just means that a company has been reducing its outstanding debt.
The Financial Times stated that Volkswagen has "almost tripled its provision for the cost of fixing cars to €16.2bn." If nothing else were to be adjusted in the company’s balance sheet statements and had left Volkswagen only the option of attaining more debt, roughly €10 billion more, to fund of this provision, the company would still retain at or slightly above its 10-quarter debt/equity average of 1.37.
Further, Volkswagen’s debt ratio would seem still slightly better than its peers in the U.S. Ford (F) and GM (GM), as shown in the table below.
Valuation
Working capital valuation (WCV)
The Motley Fool had a valuable article back in 2011 about valuing a company with regards to its working capital. The article can be accessed here. This, I consider, is in some form of modification of Benjamin Graham’s net current asset value formula.
A conservative investor would seek 50% or higher in terms of WCV. This is because in theory, if a business is to be liquidated by tomorrow, an investor will be able to get 50 cents per dollar of investment from working capital alone. This discounts everything else from the business, such as growth from earnings and cash flow. The higher working capital purchased from an investment, the better.
Volkswagen had shown otherwise, and therefore is probably not attractive as an investment option for any conservative investors as of the time being.
Some more valuations
Both the traditional price to earnings and price to book value ratios revealed that Volkswagen ADR market price is at a discount compared to its peers and the S&P 500. Nevertheless, the working capital valuation preceding appeared to be a more reliable valuation this time, and therefore would indicate that the company is superficially underpriced by Mr. Market at the moment.
In summary, Volkswagen would seem to be able to outlast this ongoing difficulties with the emission scandal. For the company to cope with the recent car emission scandal, its balance sheet would be tested. Increase in provisions and possible increase in debt and share issuance resulting into lesser appealing debt/equity ratio and shareholder dilution may reduce its share price attractiveness. Given the company’s size and somewhat tarnished brand name, I believe it will still outlast the ongoing difficulties.
Happy investing!
Mark Yu
