What is a good balance sheet and is book value equal to the intrinsic value? This article states some of the key things to look for on the balance sheet and explains that intrinsic value is often falsely seen as intrinsic value. In the end, the most important factor is what the company can earn with the assets found on the balance sheet.
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The balance sheet and book value
A balance sheet (balance meaning that both sides are equal ‘in balance’) shows the assets, equity and liabilities of a company. Simply said, it shows what the company owns that produce money (assets like inventory and a factory) and how this is financed (liabilities (debt) and equity). The balance sheet is a snap shot of the assets and liabilities of the company at a given time.
Assets – Liabilities = Equity (or book value).
The equity is also called shareholders’ equity or book value. Dividing the book value over the total number of outstanding shares will give you the book value per share. This book value per share is used in the P/B ratio (price of the share / book value per share).
More information about the balance sheet can be found here.
What is a strong balance sheet?
What a good balance sheet is differs per industry. In general, growing cash and equivalents, decreasing debt and increasing shareholders’ equity is seen as positive. Strong businesses do not need a lot of debt to operate and generate enough cash to pay down debt. Good businesses also have the ability to retain earnings (this increases equity) and to reinvest this at high returns. Furthermore, companies can purchase back shares which will also show up on the balance sheet.
A rule of thumb for the balance sheet health is often a debt to equity ratio of 0.5 (meaning 2 dollars of equity for every dollar of debt). However, companies like Unilever, Coca-Cola and Procter & Gamble have higher D/E ratios than 0.5. This is mainly due to their strong economics which allows them to have the luxury of not having to retain much equity. They often get paid before they need to pay their bills. Furthermore, it is relatively easy for these companies to get a loan if needed.
A better way to look at debt is to check the amount of debt and compare this to the income. The debt of a business is manageable is it can be repaid within 3-5 years on average. For instance, a company with an income of $1 million and $4 million of debt can repay the debt in 4 years. Debt to equity ratios rely on the book value, and this is not a source of funds. The source of funds is the cash flow of a business.
Industrials (e.g. General Electrics) often need large working capital (current assets – current liabilities) to finance their services for their clients (they get paid later). So, balance sheets can vary by industry and some industry knowledge is needed to determine if the balance is healthy. Analyzing changes in the balance sheet over a time (5-10 years) is very useful to discover improving or decreasing financial health.
Apple’s balance sheet example
Below you can find the balance sheet from the 2019 Annual Report (10-k) of Apple.
Just a quick scan shows that between 2018 and 2019:
- Cash improved from $25.9 billion to $48.8 billion
- Marketable securities increased with more than $10 billion (can be quickly converted to cash)
- Long Term debt (non-current liabilities) decreased to just under $92 billion (note that Apple’s cash and marketable securities are enough to pay down long-term debt)
- Shareholders equity went from $107 to $90.5 billion mainly due to share buy-backs and dividends (this can be found on page 32 of the annual report of 2019)
In sum, this is a strong balance sheet as there is enough cash and equity and not much debt. And more importantly, Apple can generate consistently huge amounts of cash with its assets! High returns on capital, low debt, good management… no wonder Warren Buffett concentrated more than 25% of his stock portfolio in Apple.
Book value can be over or understated
Quite often, people perceive a business as undervalued simply because the price to book (P/B) ratio is lower than 1. This means that the assets per share are worth more than the price of the share. Of course, this is according to the accounting figures.
Logically, the assets might not be worth as much as is mentioned on the book. In times of economic distress, assets are often sold for prices below book value. Inventory is likely worth much less if a company goes bankrupt. Of course, it could be true that the assets are worth more than their historic book value. An example is real estate that is listed in the books for prices of years ago.
Another example of how the intrinsic value can be understated by the book is due to the writing off (amortization) of goodwill. A company must state “goodwill” on the asset site of its balance if it pays more than the book value for an acquired company. Warren Buffett argues in his 1999 letter that the real economic value of good acquired businesses growths over time. Hence, writing off of goodwill understates the true value.
Book value is not the same as intrinsic value!
Never assume that a company is undervalued simply because the price of the share is lower than the book value per share (e.g. a P/B under 1)! It is about what the company can earn with the book not about the amount of assets. Coca-Cola trades at a P/B of more than 10! Of course, we know that the brand and the feelings that we get when thinking about Coca-Cola really determine the value.
A lot of European banks on the other hand have P/B ratio’s lower than 1. Unfortunately, most of them also have very low returns on assets and equity. So, one could argue that it is fair that these banks trade below their book value. The book (the loans of the banks basically) does not earn enough fee and interest income compared to the capital used.
Some wisdom from Benjamin Graham and Warren Buffett on book value
In the 1934 and 1940 edition of Security Analysis, Benjamin Graham states that it is a great mistake to rely just on book value:
Some time ago intrinsic value (in the case of a common stock) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value.
Benjamin Graham, Security Analysis (1934; 1940)
Additionally, Warren Buffett said in his letter of 1983 the following about book value and intrinsic value:
Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
Warren Buffett
Warren Buffett about the power of economic goodwill
Probably one of the best letters to investors of Warren Buffett is the one of 1983 with the appendix that explains economic goodwill.
Warren Buffett describes in his letter that the less assets a company needs to produce a certain level of income, the better. For example, if a company’s turns over its inventory fast, then less inventory is needed at a given point in time. This means that less capital is needed to run the business and the chances of getting obsolete inventory are lower.
Furthermore, the company has to spend relatively less on new inventory (compared to companies that need more assets) during inflationary times. Simply said, the low asset company needs to buy less new expensive assets (inflation increases the prices for the inventory). A high turnover of assets combined with high margins leads to a high return on capital.
Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.
Warren Buffett
In summary, Warren Buffett likes a business that has economic goodwill (like Coca-Cola) because this means that less tangible capital (like inventory) is required to generate income. A business that needs fewer tangible assets to produce the same amount of earnings as a company with more tangible assets is more desirable. Buffett in such cases ignores goodwill and talks about return on net tangible assets.
Putting book value in the right perspective
The balance sheet and the book value (or equity value) is very important to determine the financial health of a company. Also, the balance sheet helps to determine how profitable the company uses its assets. But ultimately, it is about what the company can earn over time (the earnings power). Excellent businesses that generate a lot of cash often don’t need much debt and have strong balance sheets.
Remember to not make the mistake of simply using a P/B ratio to determine the intrinsic value of a company. Future cash flows determine the intrinsic value of a company. And cash flows are not as definite as a book value at a certain point in time.