In previous chapters of “The Little Book of Value Investing,” author Christopher Browne explained how he found stocks selling at bargain prices. Then, how he determined whether a stock was selling because of a temporary blip or because of a serious, long-term problem.
Having gone through these two steps, an investor then has a list of manageable size. As he explained in chapter 12, there is still the matter of whittling down this last list with fundamental analysis:
“Start by examining the balance sheet. Much as a doctor consults patients’ charts to see what condition they are in, look to the balance sheet to see what shape the company is in. The doctor needs to know all the vital signs to make a diagnosis. A balance sheet is effectively a company’s medical chart, a snapshot of its financial condition at a given point in time.”
Among balance sheet metrics, Browne first focused on the company’s liquidity. How much cash or other short-term assets are available if the company needs to pay down debt or take advantage of a growth opportunity?
To get that information, add up all assets than can be converted to cash in a year or less and do the same for current liabilities. Now divide the current assets by the current liabilities to determine the current ratio; the higher the ratio, the better. For example, $200 million in current assets divided by $100 million in current liabilities means a current ratio of 2. Suppose, instead, that the assets were only $50 million; in that case, the ratio would be $50 million in current assets divided by $100 million in current liabilities, or a current ratio of 0.5.
According to the author, a rough rule of thumb is to look for companies with at least twice as much in liquid assets as in short-term liabilities, or a current ratio of 2. While this might vary by industry, it is a helpful indicator.
It also helps to compare current ratios across companies in the same industry, to assess their comparative financial conditions. Look for a company with a current ratio that at least beats the industry average. Similarly, it is prudent to check a company’s history, watching for a steadily declining current ratio.
In cash terms, the difference between current assets and current liabilities is known as “working capital,” the amount a company has available for operations and investments. If inventory is removed from the current ratio calculations, the result is known as the “quick ratio” or the “acid test ratio.”
Inventory is an interesting part of this picture. Analysts debate whether it should be included in the current ratio because while it might be converted to cash in the short term, there is no guarantee. In addition, the author recommended looking at its history over several years; if inventory rises in step with sales, then there’s probably nothing to worry about. But if inventories are going up faster than sales, then the company’s products may be going out of favor and may have to be sold at a loss.
Those were measures that arise out of current assets and liabilities. In the next section, Browne reviewed long-term assets and debt. Long-term assets include not only real estate, factories and warehouses, but also intangibles such as patents and trademarks. Long-term liabilities refers to all debt that is due more than a year after the date of analysis. In both cases, what does the company’s history show? Are assets growing along with liabilities, or are liabilities growing faster than assets (a sign of trouble)?
From the long-term assets and liabilities, an investor can calculate the “debt-to-equity” ratio. To calculate this, divide the total debt (both short and long term) by shareholder equity. If the ratio is greater than 1, the company is funded more by debt than by equity investments.
With the information provided by the ratios that emerge out of balance sheet results, an investor has a better overall view of a company’s financial strengths and weaknesses. This analysis may also uncover red flags that indicate a company has serious problems. Browne wrotre, “Evaluating not only the levels of debt, assets, and working capital but the trends in each can give you valuable information about the company’s health and future prospects.”
He went on to say, “It is here that you begin to understand how solid the book value of a company is. Recall that a low price-to-book-value ratio is one characteristic of a winning stock.”
There is a caveat, though. He argued that if a lot of the book value is comprised of intangible assets (goodwill, for example), the company may not be a true bargain. On the flip side, book value also may be understated because real estate or investments in stocks years earlier may be carried at cost.
He concluded the chapter by noting, “Remember, winning in the investment game means not losing. A strong balance sheet is a good indicator of a company’s stamina, its ability to survive when the going gets tough.”
Read more here:
- Christopher Browne: Is This a Real Bargain Stock or Not?
- Christopher Browne: How to Find Value Opportunities
- Â Christopher Browne: Finding the Silver Lining When Markets Dip
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