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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Understanding Financial Statements Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions


Balance Sheet Analysis

 - Leverage and financial
   strength affect share value

 - Liquidity concerns can
   decimate a business

 - Cash is critical, to a point
    * Window Dressing
    * Cash Gap
    * Cash per Share
    * Burn Rate

 - Marketable Securities

 - Receivables are interwoven
    with cash flow
    * Past Dues and Write-offs
    * Receivables turnover ratios
    * Securitizations

 - Inventory - focus on the
   profit margins
    * Perpetual vs. Periodic
       Inventory
    * Inventory Accounting
       Calculation
    * Inventory Costing Methods
    * Lower of Cost of Market
    * Inventory Categories
    * Inventory Turnover Ratios

 - Fixed assets are necessary in
   order to be a world class
   company

 - Liabilities with equity attributes
   are enriching

 - Emphasizing debt net of cash
   can be misleading

 - Book value is a tool to
    properly evaluate a stock

 - Off-balance sheet assets and
   liabilities are legal

 

 


Book value is a tool to properly evaluate a stock

The shareholders’ equity section of the balance sheet is one of the most informative yet least understood portions of the balance sheet. Many investors don’t realize that shareholders’ equity is also referred to as book value. When reviewing a balance sheet, start by understanding the book value, both per share, as well as absolute. Always compare book value per share with the current share price, to get a quick appreciation of the premium or discount from the accounting value one is paying or receiving for the stock. This is a good initial way to start focusing on what is a reasonable entry price for a stock.  Currently (March 2007), the S&P 500 companies sell for approximately 3.1 times book value. The author, however, looks for companies selling at or below book value.

Dissecting book value is important. By subtracting, from total book value, intangible assets like goodwill and prepaid expenses, investors can gain an understanding of the accounting value of the hard assets that support book value. This is called “tangible net worth;” while it’s not market value, it is a good benchmark figure.

Start thinking in terms of what is the amount of “air” that you as an investor are willing to pay for. The difference between the market capitalization of a company and its tangible net worth is the amount of “air” in a stock. One can easily convert it to a per share figure. Market capitalization represents the amount of shares a company has outstanding, times its share price.  Investors need to decide if the company’s cash flow or potential cash flow is sufficient to both cover the equity and “air” in the stock, and to make an adequate return for themselves. 

Investors can also determine, by reviewing book value, the origins of the company’s equity. Did the company grow its book value through earnings or did it just raise capital. The category retained earnings is there for that reason, and represents the historical earnings of a company that management did not give back to its shareholders as dividends. It is a positive indication if book value was obtained through earnings, rather than just through stock sales. While historical earnings cannot predict future earnings, they are reflective of the pedigree of a company.

Investors also need to understand the magnitude of (and decide if they can live with) what I call “hidden backdoor expenses.” The professionals call these comprehensive income items. In actuality, these are mainly expenses that bypass the P&L and are charged directly to owner’s equity, such as minimum pension liability adjustments, deferred stock compensation, foreign exchange translations, and unrealized gains or losses on marketable securities and derivative instruments.

There are many companies that report positive P&L returns, but are losing a great deal of money on these hidden recurring expenses that are charged directly to equity. These hidden expenses can be enormous, especially in some of the older and more established companies. Eventually, as book value erodes, the stock price will be negatively affected. I’m saddened by the fact that company pension plans across this country are short funded by over a hundred billion dollars. The magnitude of this shortfall, however, can eat away at companies’ profits forever. Understand, when investing in these types of companies, the net income of the company that normally belongs to the shareholders is now going to the employees or other non-owners. As an investor, where does that leave you, your family, and the stock price?

 

 

 

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