5. Valuation Methods
5.2 Analyzing the Balance Sheet
The next part of the analysis involves analyzing the balance sheet. As mentioned in the earlier chapter, the main objective of the balance sheet is to see how healthy the firm is in terms of paying its debt, maintaining its business activities and how much the company is worth per share based on its current holdings. It also shows the different kind of assets the company is holding, which can determine which assets are the biggest uses of cash. To get to this, we have to compute a few essential ratios and calculations.
The figure above is a sample Balance Sheet of a hypothetical company. The line items shown above are some of the more important pieces of information from this statement. Although many balance sheets in real life have many different complicated lines with different terms, they essentially fall into one of these groupings. From the looks of the figure, it may look pretty intimidating but do not worry. We will go through each sub category and soon you will have a much better understanding of the balance sheet. You can also refer to the glossary link to see some of the definitions of each line item which explains to you the meaning of these terms. I would suggest that you take some time to digest some of these definitions before you continue reading this part of the tutorial. Another thing to note: Some annual reports only show you the numbers for 2 years. It is always good to have 3 years of data so that you can identify some of the movement trends within the statement. Described below is a guideline of a process you can use to analyze the Balance Sheet:
2.1) Ratio Analysis
Ratio analysis is one of the most important analyses that have to be done when analyzing the balance sheet. It can be split into 4 different sub categories: Profitability Ratios, Liquidity Ratios, Debt Ratios and Working Capital Ratios.
Profitability ratios show how efficient the company is in using either its assets or equity to generate profits. In this analysis, the ratio we will use here is the Return on Equity (ROE). ROE is defined as Net Income/Equity. From the balance sheet above, the ROE is calculated as follows:
As you can see, ROE has been increasing from 2007 to 2009, which means that the company is able to generate more profits from its capital as time progresses. This is always a good sign of sustained profitability. Do also reference the ROE for its main competitors and see how it compares with them.
Liquidity Ratios help to determine whether a business has enough capital to maintain its business activities on a day to day basis. If liquidity ratios are bad, a company may not be able to pay its suppliers or interest on loans on time which may create problems such as a disruption in operations or even filing for bankruptcy in the worst case scenario. Therefore, it is highly important that a company monitors its liquidity well. The ratio that we will use to here to analyze liquidity is the Current Ratio. It is defined as Current Assets/ Current Liabilities. In this example, the current ratio is calculated as follows:
Generally, a current ratio above 1.5 is considered healthy. In this example, the current ratio of the company from 2007 to 2009 has decreased slightly but still remained above the healthy level.
Another important ratio to calculate for the balance is the debt ratios of the company. This gives an indicator of how much debt as a % of assets or equity that the company is currently holding. The higher the debt, the more risky the company is because a once a company is unable to pay off its interest payments on these debt, there may be huge penalties that they have to incur, such as a drop in credit ratings or even bankruptcy in the worst case scenario. Therefore, it is essential that we see how much debt the company takes on and whether it has the financial strength to pay them off. 2 ratios need to be computed here, Debt to Asset Ratio and Debt to Equity Ratio. The Debt to Asset Ratio is computed as Total Debt/ Total Assets and Debt to Equity Ratio is calculated as Total Debt/ Total Equity. To compute total debt, you have to add the current portion of borrowings to the long term borrowings in the example. For actual balance sheets, there might be a few more line items pertaining to debt such as Bank loans or long term bond issues found under the liability section of the balance sheet. Make sure you account for them as well when computing total debt. In this example, the debt ratios are calculated as follows:
From these ratios, you can see that total debt as a % of assets in 2009 is 20% and has been increasing from 15% in 2007 to this number. Also total debt as a % of equity is 30%. These numbers are fairly low which means that the company is not taking on a lot of debt and the asset or equity base of the company is large enough to sustain this amount of debt. When the debt to Asset ratio goes above 50% or if the debt to equity ratio goes above 100%, it is a sign that the company is taking on substantial debt. Taking on debt in itself is not such a bad thing as they would have more capital to fund their growth. It is however the ability to pay off such debt that is key to these companies. In that scenario, use the Times interest ratio from the income statement as an indicator whether the company is able to pay off its debt periodically.
2.2 Price to Book Ratio
We have discussed earlier about the concept of the PE and PEG ratio. Another ratio which can potentially tell how cheap or expensive a particular stock is worth is the Price-to-Book ratio or PB in short. The PB ratio is calculated as the current stock price/ (total equity divided by number of shares outstanding). In this example, the PB ratio is computed as follows:
Generally, a stock which has a PB ratio of less than 1 is undervalued. This is because this means that the price of the stock is worth less than the current value of equity. What this implies is that the market thinks that the company is expected to make losses in the future which will result in equity getting lesser. If that is not the case and you have ascertained that the company will continue to make profits, a PB ratio less than 1 is a good indication of an undervalued stock. However, it is not as easy as it seems and most stocks in the market have a PB greater than 1 which takes into account its future earnings but it is always good to have an indicator of how expensive a stock is compared to its actual book value. Compare this value across different companies to see whether your stock is undervalued compared to the industry.
To summarize, we have done the following analysis for the balance sheet:
1) Calculate key ratios to determine profitability, liquidity and debt as a % of assets and equity
2) Calculate the Price to Book value of the company to determine if it is potentially undervalued compared to its main competitors.
Other sections within Valuation Methods:
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