In this post I continue to look at the balance sheet, but now I will consider liabilities and equity.

Balance Sheet

In the previous post I discussed elements pertaining to the assets on the balance sheet. In this post I will focus on liabilities and equity. 

Liabilities
Liabilities are also classified into current and non-current liabilities. Similar to assets, current liabilities are defined as anything that will have to be settled (paid) within 12 months. All other liabilities are non-current liabilities. 

Equity

Typical Liability Adjustments

As mentioned in The Financial Statements 1 performing either book value, replacement value, or liquidation value revaluations requires adjustments to the entire balance sheet (assets and liabilities) in order to reflect the economic value of the balance sheet. Being a value investor makes me a conservative investor. Therefore, I don't like to fiddle with liabilities much and take a very conservative approach to making any adjustments. Below is a short list of (typical) liability adjustments:

• I accept any prepaid expenses at book value
  
• Leases
  
• Options
  

As mentioned before, I approach adjustment to try and ensure that I am "approximately right rather than precisely wrong". These adjustments can be tricky and would be happy to answer any questions about them. Feel free to contact me and I will gladly provide examples and explain them as well.

Net Asset Value or Book Value

Finally, we get to the valuation discussion. I have been working toward this point to allow the user to perform an asset valuation. With an adjusted balance sheet the process of determining the Net Asset Value (NAV) or Book Value (BV) is simple. You subtract the adjusted Liabilities from the adjusted Assets, which leaves you with the NAV. If you take this value and divide it by the diluted number of shares you have the NAV or (better known) BV per share. 

BV can be used for many different purposes. For instance, from here you can calculate the Price-to-Book ratio by dividing the current market price per share by the book value per share. This is an important ratio for value investors as we like to focus on companies with low price-to-book values. Price-to-book is so important that Benjamin Graham used it in the following manner:

• Price-to-book ratio sets the floor for a stock price (if price-to-book was calculated using liquidation assumptions then under worst case scenario this ratio indicates how much of your investment you will recover)
• Higher price-to-book ratio's indicate greater risk during liquidation (i.e. the less likely there will be enough assets to pay all the debts and have money left for shareholders)
• If price-to-book ratio's move or become much higher than reasonable (or normal) for a particular stock or industry it could be a signal to sell (if an alternative investment, promising better returns, is available or if something fundamental in the business has shifted and requires exit)
• Inspect and screen out companies that don't have stable and growing yearly book values per share. Book value per share, as Buffett says, is the proxy he uses for determining intrinsic value per share. He considers it so important that he measures himself and Charlie Mungers' performance at Berkshire Hathaway in terms of yearly increasing book value per share (as reported in Berkshire's annual report - usually on page 2 of the annual report!)
• He screened out any stock which had a Price-to-book ratio, multiplied by Price-to-EPS ratio, of more than 22. Graham called it his Price-to-book test.

My aim here was to calculate book value per share (of the existing assets and ignoring any growth assets), which we have finally achieved. I have also briefly touched on some important aspects of book value (i.e. using price-to-book value as an example). There is much more to be said on understanding various ratio's (especially when screening possible investments or when performing a relative valuation). In a follow-up series of posts I could stop to discuss these.

Book value seems to become very important overnight when times are hard (I wonder why...!?). I use book value per share as an indication of intrinsic value per share (see value continuum to understand where book value fits in) when considering whether to buy a share at a given market price. Therefore, I like quality companies trading at low price-to-book values, e.g. an established company with a durable competitive advantage, good management and a price-to-book ratio of close to 1 is fantastic! I consider anything near 1 and up to 1.5 or 1.6 very acceptable.

I should however also warn against the weaknesses of book value. For industrial companies with fixed assets book value provides good insights. For companies in the service industry (e.g. consulting firms) business book value could be misleading. Due to relatively small asset base they will typically trade at higher price-to-book values. Value investors who has a circle of competence in this area, and invest in it, will have to adjust their screening criteria to consider these higher ratios. Also, companies growing fast will have higher than average price-to-book ratios and again the value investor focusing on companies in this phase of their business life-cycle will adjust their valuation criteria to consider this.

Next Steps (...next posts)

Next I will look at the Income Statement and Earnings Power Value. Once this is done I will review the growth assets and the two Discounted Cash Flow (DCF) valuations starting from respectively Free Cash Flow to Firm and Free Cash Flow to Equity holders. Once done we will have all three intrinsic value estimates for a firm, i.e. the asset value, earnings power value and growth values. 

Please send me your comments or questions. I look forward to hearing from you.

Be Extraordinary!
Myles Rennie 

This post puts together the previous discussing valuations and the financial statements. Therefore, to understand where are how this post first in you should read the proceeding posts please.

The Valuation Process

To start off I will talk about the truth of valuation. Firstly, all valuations are biased. No one starts with a blank sheet and we all approach valuation with our own views before even starting, e.g. it starts with the companies we choose to value. With professional analysts there are institutional factors that create bias, e.g. herding, window dressing, etc. The inputs to your valuations reflect your optimistic or pessimistic position, e.g. loss aversion, lotteries, etc. Then there is the post valuation garnishing's

Most valuations (even good ones) are wrong. We expect to get the right answer when we follow the right steps. While this is true in baking and science, it is not the case in valuation. Even if your data sources are impeccable, they have to be converted into forecasts.

In order to find (screen) and evaluate investments stocks I use the process described below.

Finding value investments takes a lot of time and effort. At Richland IH we use Validea to help us screen our possible investment candidates. Once Validea shows me possible candidates I start using the process above.

The Value Continuum

Putting the Balance Sheet (existing assets), Income Statement (earnings power), and growth assets together allows me to define the value continuum (see figure below). The first valuation I posted on this site, i.e. the one done on Bowler Metcalf Ltd, demonstrated this continuum perfectly.

In Bowler's case the asset value was consistently less than the earnings power value which, in turn, was less than the growth value. As explained in the analysis, this is a sign of a firm with a durable competitive advantage, i.e. the kind of firm a value investor loves to invest in all else being equal. 

These three intrinsic value calculations will always form the basis of my firm valuations. Once intrinsic value has been determined the true value investor will only make purchases only at prices far enough below intrinsic value to provide a margin of safety that would offer appropriate protection against the variance in the different valuations. 

Please Note - DCF (growth value) Equity versus Firm Valuation

When valuing a business (using a Discounted Cash Flow approach) there are two ways which we can approach it. The first is to value the entire business, both assets in place and the growth assets.  This uses the Free Cash Flow to Firm, and Weighted Average Cost of Capital, generated by the business in the DCF and this is called the enterprise value. The second method is to value the equity in the business. This uses the Free Cash Flow to Equity, and Cost of Equity, generated by the business in the DCF and is called the equity valuation. These two values are tied to each other and the net difference between the two is the value of any cash & marketable securities and net debt position of the business.

When I perform a growth intrinsic value calculation I do both (equity value and firm value) just to make sure I have not done something wrong. These two figures are never exactly the same, but they are usually close enough not to make a difference and that's good enough for valuation purposes.

I will not delve into more of the detail here. I will spend more time in a follow-up post to provide more detail. I hope this brief overview has provided you with some insights into the financial statements and how they are used to help you understand intrinsic value.

There is so much more to add to this subject, just consider the hundreds (or thousands) of books available on this subject and the importance to the economy and our lives in general. I want to write much more on this matter and I will add ideas and special posts in future on this subject. I will try and pick topics and ideas that are specific to value investors in order to help them make better investment decisions. 

Please send me your comments or questions. I look forward to hearing from you.

Be Extraordinary!
Myles Rennie