Before I start my next valuation (it will be done on Assore Limited) I want to spend some time focusing on why and how value investors look at both the Balance Sheet and Income Statement of a company when performing a detailed analysis of a company.

Overview

Many people don't like spending time reviewing financial statements. There are many reasons for this, e.g. they might not understand it, it might be too much work, they could be following an investment strategy that does not require study of any financial statements. Unfortunately (or in my case fortunately) the true value investor has to spend time studying these black-and-white pages containing the information required to make good investment decisions. For a value investor the intrinsic value of an investment lies hidden in the financial statements. By gaining a rudimentary understanding of these (easier than expected) documents investors will find that they are not as scary as they first seem.

When studying financial statements there are my point to consider. The value investor should consider that:

• The balance sheet tells about the firms Assets, Debt and Equity. Assets, the core of most businesses (at least most value investment businesses), can tell about stability, safety, growth potential, and the quality of management. Debt can help firms grow, but increases the riskiness of a business during economic distress. Debt places a burden on earnings and too much of it has lead to the downfall of many businesses.
• The income statement tells about a firms revenue, quality of earnings, sales vs. operational efficiency, has the ability to highlight potential, earnings, and the quality of management.

I will here again repeat Benjamin Graham's definition of an investment: "it is an operation which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." Safety, in Graham's opinion, is measured in terms of stability based on known information. When valuing stocks (i.e. determining intrinsic value) Graham focused on current information contained in financial statements, and not as much on predicting the future. In a speech in 1975 he is quoted as saying: "I have resolutely turned my back on efforts to predict the future." 

Intrinsic value is an elusive concept. Ask 10 people to value an asset and you will receive 10 different answers. Value investors have been debating for many years whether to focus on the quality of assets and the balance sheet  or whether to focus on the quality of earnings and the income statement to determine intrinsic value. Even the best known value investor of all time, Warren Buffett, has changed his opinion on this matter over the years. In the past he often emphasized the importance of the income statement (for quality earnings and growth) and in recent years he has shifted partially back to assets that can sustain and help a firm in times of recession, inflation, etc. Irving Khan, Graham's teaching assistant at Colombia University, said: "We stress balance sheet and assets. We're old fashioned because our paramount aim is preservation of capital." Walter Schloss, another of Graham's disciples who recently passed away, also emphasized the importance of the balance sheet. These investors all obtained impressive compound annual returns over many years.

I prefer a balanced valuation view to include the following three elements:

• Existing assets derived from the balance sheet
• Earnings power derived from the income statement
• Growth assets, and related earnings potential, derived from growth assets (determined by reinvestment rates, etc.) on the balance sheet

If a company can present a compelling investment opportunity based on all three investment approaches, then I feel comfortable to consider investing, but only if I can buy at the right price and after passing my Phase I criteria. 

Balance Sheet

I like Janet Lowe's analogy of the income statement and balance sheet in her book The Triumph of Value Investing. She says that if a firm was a ship the balance sheet would be the hull and the income statement would be the sails. The hull keeps the business afloat while the sails - propelled by sales - moves it forward. With this analogy in mind, let's start considering what details of a business' hull do we need to check in order to determine whether it will remain afloat. 

The balance sheet works according to a simple core relationship, and it is:

   Assets = Liabilities + Shareholder Equity

Balance sheets work based on accrual accounting, meaning that revenue and expenses are recognized in the periods in which they are incurred, irrespective of whether cash was involved. It is therefore a statement of financial position, a snapshot  of the assets and liabilities at a single point in time. When I start looking at the balance sheet, I focus on five key aspects:

• Existing assets
• Growth assets
• Cash, marketable securities and investments
• Debt
• Equity, dividends and retained earnings
  

Assets
Let's first consider the difference between existing assets vs. growth assets. Aswath Damodaran, in his book Demodaran on Valuation: Security Analysis for Investment and Corporate Finance, argues that the value of a business could be considered the sum of the values of the individual assets owned by the business, as opposed to the discounted value of all expected future cash flows generated by the assets the business owns. He favours valuing businesses as going concerns, i.e. discounting the conservative future free cash cash flow of the business (generated by assets it already owns and assets it expects to invest in in future) by a risk-adjusted discount factor. To better understand these two 'classes' of assets he proposes visualizing the balance sheet in the form of a 'financial balance sheet' (as opposed to an accounting balance sheet) with investments already made as 'assets in place' and investments we expect to make in the future are 'growth assets'.

Growth assets only play a role in my growth valuation, performed as the last of three valuation techniques to determine the intrinsic value of a firm (see the image in the section The Value Continuum below). It is clear the picture above that pure asset-based valuations will yield lower values than going concern (or growth) valuations. 

A couple of brief ideas on assets. Assets are classified as either current or non-current and then there is the distinction between tangible and intangible assets. Current assets are defined as anything that will be turned into cash within 12 months under normal operating conditions. These include cash, cash equivalents, short-term investments, accounts receivable, inventory, and different types of prepaid accounts (e.g. tax). All other assets are non-current assets. Assets can alternatively be classified as tangible or intangible. Tangible assets are sometimes called hard assets and include things like inventory, property, plant, equipment, and cash. All other assets are classified as intangible.

Cash
Cash gives a company the ability to weather hard times or take opportunities. On the other hand cash does not earn good returns. Stable cash positions indicates the existence of a durable competitive advantage (in cases where debt levels are consistently low - else debt can be used to smooth cash positions) and eludes to quality, conservative management. Too little cash can constrain the business and stop it from growing or staying afloat.

In order to calculate growth assets intrinsic value I will return to cash and specifically the concept of Free Cash Flow, i.e. cash available to the firm or to equity holders after working capital and capital expenditure requirements have been considered. What I would like to say here is that stability in free cash flow, and more specifically positive average free cash flow, is important to the value investor. Free cash flow could be negative for many reasons and could:

• signal good things in future, e.g. high growth companies investing more than it is earning
• signal danger, e.g. companies slowly dying and has negative earnings or consuming itself by divesting assets or shrinking capital
• signal possible good returns, e.g. companies that in the past over-invested (capital overspending) and could now benefit from it in the next couple of years
  
• signal that management might make new stock issues or raise debt (in the case of persistent, even short-term, negative FCFE) 

Understanding cash positions, working cash, excess cash, free cash flow, and the application of cash in a company is very important...and a subject on its own.

Liabilities and Equity to be discussed in a following post, i.e. Financial Statements 2

Typical Asset Adjustments

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. Typical adjustments include revaluation (mark-to-market) of investments, considering non-operating assets, etc. Please note, and this is very important, that the adjustments made differ for book value calculations vs. replacement asset value calculations! Below is a short list of (typical) asset adjustments:

• Marketable securities and short-term investments - determine present market value by marking to market
  
• Accounts receivable - adjust to net realizable value (book value) or economic value (replacement asset value), e.g. bad debt allowance must either be netted or added
• Inventory consist of raw material, work in progress, and finished goods. If it will be sold in 12 months it will be included in current assets else non-current assets. Adjustments to inventory can be tricky, for instance, if the inventory control system is LIFO and prices are rising then a LIFO reserve (often as high as 20%) has to be added to the inventory asset. To determine any other adjustments to inventory the analyst must determine whether inventory days have been increasing (i.e. inventory turning slower). If it has been increasing then inventory asset value has to be adjusted downward based on the following rules: more commodity type inventory should be adjusted down a little (e.g. down by 25% or 75% of the original value), unsalable inventory should be adjusted down more ( e.g. down by 50% or 50% of the original value), and specialized inventory should be adjusted down the most (e.g. down by 75% or 25% of the original value)
• In the case of replacement asset value prepaid accounts (like deferred taxes), to be 'turned into cash' or 'bartered' within the next 12 months, should be discounted to present value. Using a discount rate of 15% this yields a discount factor of (1/(1+15%)^1=86.95% (i.e. down by 13% or 87% of the original value). In the case of deferred tax assets, it should be offset against any deferred tax liability, and the remaining amount (either asset or liability) should be discounted to its present value (PV) by the appropriate discount rate
• Property, plant and equipment should be considered separately. In the case of a reproduction valuation the  historical cost of the different categories of PPE (i.e. property, plant and equipment) have to be considered individually. Property could be estimated based on current market values (or rather fair market values). Plant and equipment could probably be reduced as a result of technical innovation constantly driving down prices (except if plant has recently been replaced)
• Goodwill, when referring to intangible assets used to create value for the firm such as product portfolio, special licenses, customer relationships, competitive advantage, intellectual property, and so on, will probably have to be adjusted upward in order to determine true asset value. However, be careful not to be too optimistic when calculating realistic asset replacement or economic value. It is often not possible to accurately calculate the value of these intangible assets, and here Prof. Bruce Greenwald suggest a shorthand, i.e. use a multiple of the selling, general, and administration (SGA) cost, in most cases between one and three years' worth
• Capitalization of R&D expenses. Often companies expense R&D costs on an annual basis. However, these are actually assets of the company and have to be treated as such. I realize that most value investors shy away from companies with substantial R&D divisions and will therefore never be faced with having to consider capitalizing R&D. For completeness sake, and for situations where needed, I will briefly explain the process here. To capitalize R&D assets we have to start by considering how long it takes, on average, for it to be converted into commercial products. We can take here, as example, five years, which I will consider to be the amortization duration for the asset. Next I have to collect the cost of the expense over the past years ranging back to the amortizable life of the R&D asset. If this cost was uniform then I can calculate the value of the asset as the proportionate sum of the expense over the last five (I chose five as an example) as 1/5 of the cost 5 years ago plus 2/5 of the cost 4 years ago plus 3/5 of the cost 3 years ago plus ... and this years entire R&D expense to arrive at the value of the R&D asset (these are the unamortized amounts of the asset left if assumed that the lifetime is 5 years and the amortization process is linear across the lifetime, which yields 20% per year over 5 years). The effect of book value of equity is therefore: adjusted book value of equity = book value of equity + value of R&D asset. There is however an additional element to consider, and this impacts the Income Statement. The operating income has to be adjusted to consider amortization of the asset instead of the R&D expense. Adjusted operating income = Operating income + R&D expense - Amortization of R&D asset. 
• Other adjustments. There are other adjustments than can be made, e.g. financing subsidiaries (e.g. BMW financial services), non-consolidated subsidiaries, prepaid pension assets, etc. These assets must be approached with caution and any adjustments must be carefully considered. In case of doubt, be very conservative and either exclude from the balance sheet or show at low values. In cases where operating expenses (or one of expenses) are capitalized as assets (and subsequent adjustments) care is needed to consider whether the adjustment has a pre-tax or post-tax effect on the Income Statement. Capitalization of pre-tax expenses, like R&D expense, is entirely tax-deductible and therefore no more adjustments are needed. Some companies, like Coca-Cola, could consider capitalize advertising spend because one can argue that it contributed to their brand value. Other companies, like consulting houses, could consider capitalizing recruitment and training fees of their most valuable assets, i.e. people. Amazon could capitalize SGA costs arguing that these expense contribute to brand value and help bring in new long-term customers.

What we are trying to achieve with these adjustments is to be "approximately right rather than precisely wrong". I acknowledge that to value an asset with 100% accuracy is very unlikely, but it is possible to value it within an acceptable margin of safety. 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.

Next Steps (...next posts)

Next I will look at some of the other Balance Sheet items (Liabilities and Equity) and then move on to the Income Statement (for the Earnings Power value) and then the growth assets (for the Discounted Cash Flow valuations).

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

Be Extraordinary!
Myles Rennie

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