How to value a company – balance sheet

Foreword

This post discusses some common techniques on evaluating the fundamental value of a company by looking at its balance sheet, for those who are investing, as defined in Investing vs Speculating.

There are, of course, other ways of evaluating the value of a company, which we will cover in other posts. Other posts in this series:

• How to value a company – income statement
• How to value a company – cash flow statement

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

What does a company own?

In the previous post of this series, we considered how a company operates, by looking at its income statement. In this post, we focus instead on what a company is, or more accurately, what it owns.

We have already discussed in the previous post how a model company operates, and how its earnings and sales numbers affect our decision on how much the company is worth. But sometimes, a company does not actually have operations. For example, a holding company is essentially just a legal container that “holds” other companies. The holding company itself has minimal operations — it is mostly only a corporate shell to provide some amount of bookkeeping, legal and financial services to the companies it owns, and it is those companies that have actual businesses and operations.

Trying to value a holding company using P/E ratio, P/S ratio or any metric that falls out of its income statement will necessarily lead to misleading numbers — the main value add of the entire conglomerate is not so much its corporate operations, but the operations of its individual constituent companies.

While we can passthrough the underlying metrics of all the children companies, aggregate them and then compute our valuation ratios based on that, the result is also likely confounding — the children companies may be in different sectors/industries, and at different stages of their corporate lives. Combining revenue and expense numbers across drastically different companies rarely makes a whole lot of sense.

While a holding company is an extreme example, there are certain sectors/industries where purely looking at the income statement of a company can lead to misleading answers. For example, there are companies where a lot of the company’s value is in its assets (such as intellectual property, rights to certain natural resources, actual physical assets that appreciate, etc.), and the assets generally does not depreciate in value quickly (or may even appreciate!). For these companies, even if they do not have any operations, you can make the case that they have value — their assets can be sold or leased to others to generate potential profits.

For companies in these situations, a better way of valuing the company may be to just look at what the company owns — by looking at its balance sheet — and then computing the value of each component and adding them all up.

Common accounting terms

Even in our simple model of a company above, a lot of interesting terms pop up. Understanding how to read a company’s balance sheet will require some basic understanding of these terms.

Note that balance sheets tend to be more freeform, with companies having a decent amount of leeway of defining line items. Because of this, we’ll only discuss line items that are more common across different companies. Sector/industry/company specific line items tend to be self descriptive.

Cash and cash equivalents	The amount of cash, usually USD for American firms, as well as any of the company’s assets that can be converted into cash immediately. These include things like bank account balances, very short term bonds, etc. Example: Our wooden figurine company has $2,000 in a bank account, and $3,000 worth of 3months US Treasury bonds. Total cash and cash equivalents = $2,000 + $3,000 = $5,000
Accounts receivable	The amount of money that a company is owed by its customers due to goods or services that were already delivered. In business, especially international trade, it is common for goods or services to be delivered, before the invoice for payment is sent. The payment, itself, will be further delayed, often with a 30-90 days grace period after invoice was delivered. While the payment is pending, the amount of money owed is classified as “accounts receivable”. While it is common for businesses to, essentially, offer short term (and often interest free) loans to their customers via deferred payments for goods and services, investors should be careful to at least verify accounts receivable makes sense. If the number keeps ballooning, to the point where it is more than 30-90 days worth of sales, then that suggests possible issues with one or more customers’ ability to pay. In these cases, such accounts may have to be labelled delinquent and written down (i.e: the company may have to realize a loss), instead of being listed at full value as “accounts receivable”. Also, a business where a large part of the current assets (see below) are in accounts receivable is naturally more risky — they are at the mercy of their customers. History is rift with examples of companies where their opportunistic customers decided not to pay up when the company is in financial trouble — if the company does indeed go bankrupt, there is a good chance that the customer may end up not having to pay at all. The higher a company’s account receivables, the more damaging such tactics from unscrupulous customers may be. Example: Our company has a regional wholesaler for the Asia region. Figurines are sent to the wholesaler, who then pay for the figurines when they are actually sold (i.e: sale by consignment). The wholesaler pays our company once every quarter for the figurines that were actually sold, and the company will send out a fresh batch of figurines to replace those that did get sold. Last quarter, the wholesaler reports sales of $6,000, which will be paid at the end of this quarter. Therefore, accounts receivable = $6,000.
Inventory	The amount of products that the company has which has not been sold yet. This is valued at cost — the cost of producing that amount of products, including cost of raw materials, as well as labor to produce the product. Example: Our company has 1,000 finished wooden figurines that it has not sold yet in its own warehouses. It also has another 500 figurines with the wholesaler mentioned above. Recall from our previous post that each unit costs $9 to manufacture. Total inventory = 1,500 units. Inventory value = 1,500 * $9 = $13,500.
Prepaid expenses	The dollar value of goods or services that the company has prepaid for. Example: Our company rents a factory for their woodcarvers to work in. The quarterly rent is $6,000 as noted in our previous post. However, the lease agreement is for rent to be prepaid annually. So, our company pays $24,000 annually on the first of the year, but only gets to expense $6,000 per quarter. Therefore, at the end of Q1, our company has prepaid expenses = $24,000 – $6,000 = $18,000.
Current assets	Current assets refer to all assets that a company owns, that are expected to be easy to sell or used for operating purposes. These assets typically include cash and cash equivalents, accounts receivable, inventory and prepaid expenses. Example: Our company has current assets = cash and cash equivalents ($5,000) + accounts receivable ($6,000) + inventory ($13,500) + prepaid expenses ($18,000) = $42,500.
Goodwill	Goodwill is an intangible asset, that is accrued when a company buys another company. It is the difference between the price paid for the acquired company and the net book value of all the assets and liabilities actually acquired. Remember that a company is generally worth more than the sum of its assets, because there is value in the act of putting together the assets and organizing them in a way that makes them productive. The company’s brand may also be valuable — customers tend to develop sentimentality towards brands they are familiar with, so even if 2 companies produce exactly the same product, customers tend to prefer the brand they’ve used before. The more mundane reason why goodwill is generally recorded on the balance sheet, is because accounting generally requires a balanced ledger — whatever a company pays to acquire another company, should be exactly equal to the “value” that the company gets from that purchase. The physical assets of the company acquired are easy enough to value and add to the balance sheet, but since companies almost always sell for more than the sum of their physical assets, in order to balance the ledger, the goodwill entry is created to hold the remaining “value”. If a company overpays for another company, then the goodwill line item tends to swell up. As it becomes obvious that our acquirer has overpaid, it is eventually forced to “impair” the goodwill (i.e: write it down), by taking a loss. While the loss is an explicit acknowledgement that our acquirer has overpaid (or our acquirer has been such poor stewards of the acquired company that it has lost value), it does allow our acquirer to realize a loss, which can then be used to offset profits to reduce taxes. Example: Our company decides to buy another company in a merger-acquisition. The other company has total tangible assets of $30,000, and debt on its books of $10,000. Our company paid $53,000 to acquire that other company. Goodwill = Acquisition price ($53,000) – total assets acquired ($30,000) + total debt acquired ($10,000) = $33,000.
Total assets	A company’s total assets is simply the sum of its goodwill, current assets, and any other assets that cannot be easily sold or used (i.e: non-current assets). Example: In the case of our company, there are no other assets other than current assets and goodwill, so total assets = current assets ($42,500) + goodwill ($33,000) = $75,500.
Accounts payable	Accounts payable refers to the amount of money a company owes its suppliers for goods and services that have already been rendered. Recall that accounts receivable refers to the money owed to a company for goods it has already sold, but has not yet received payment on. Accounts payable is simply the reverse of that — suppliers for a company may have already delivered raw materials that the company has not yet paid for. These are recorded as accounts payable. Example: For the upcoming quarter, our company expects to sell 1,200 wooden figurines, and thus require 1,200 blocks of wood. These raw material has already been delivered by the supplier, and our company has 60 days to pay for the wood. Recall that each block of wood costs $5. Accounts payable = 1,200 * $5 = $6,000.
Current liabilities	Current liabilities refer to all the liabilities that our company has to meet within the year, or its normal operating cycle. This typically includes accounts payable, any interest due on debt in the calculation period, any dividends that have been announced, any taxes owed but not yet paid, etc. Example: Our company has long term debt with annual interest only payments of $1,000. Therefore current liabilities = accounts payable ($6,000) + interest payments ($1,000) = $7,000.
Total debt	The total debt of a company refers to all outstanding loans it has taken out. Total debt includes account payables, all other short term loans (such as bank loans, revolving credit facilities, etc.), as well as all long term loans. In short, total debt. Example: Our company has long term debt with annual interest only payments of $1,000. But that’s not the actual debt amount. Let’s say that debt carries a 10% interest rate, which means the actual long term debt is $10,000. Therefore, total debt = accounts payable ($6,000) + long term debt ($10,000) = $16,000.
Deferred taxes	Deferred taxes can exist as either assets or liabilities (or both!). In the asset form, it is simply something the company owns, that can reduce future taxable income (and thus future tax liabilities). For example, a company may choose to prepay some of its tax obligations in the future. In the liability form, it is the opposite — it is tax due for the current period, but not yet paid. Therefore, it’ll need to be paid in the future. The most common type of deferred tax asset is a loss carryover. For example, our company had a loss this year, it generally won’t get a payment from the IRS (reverse tax!). Instead, it’ll carry the loss on its balance sheet as a deferred tax asset, valued at the amount of the loss multiplied by the tax rate. Whenever the company starts making a profit, these deferred taxes can then be used to offset the taxes due at that time. The most common type of deferred tax liability is depreciation, typically for real estate. As mentioned in the prior post, depreciation is an estimate that is rarely right on a year to year basis. However, it is not free money from the IRS! When an asset is depreciated for tax purposes, its cost basis is reduced. When the asset is finally disposed of (sold off, in this case), the sales price is compared to the cost basis. If the sales price is greater than the adjusted cost basis after depreciation, then the difference is taxable capital gains. In that sense, if a company estimates that accounting depreciation is likely to reduce the cost basis below the actual value of the asset, it can carry the tax benefits of that depreciation on its balance sheet as a deferred tax liability.
Minority interest	Minority interest is a noncurrent liability carried on the balance sheet of companies to reflect that they may not own 100% of the businesses or child companies on their balance sheets. Example: Our company bought a 80% stake in a competitor for $20,000 (i.e: the competitor is valued at $25,000). Because our company is effectively the controlling interest in the competitor (a child company), all the assets of the competitor (all $25,000) appears on our company’s balance sheet. However, our company does not own all of those $25,000 brought onto its balance sheet. Instead, $5,000 belongs to the original owner of the competitor company. This $5,000 is carried on the balance sheet of our company as minority interest.
Reserves	Reserves represent money set aside by a company to pay for future obligations. For example, insurance companies carry payouts to customers that are due in the future as reserves on their balance sheets; Banks carry estimated future losses from loans as reserves on their balance sheets; Companies being sued carry potential legal settlement costs on their balance sheets as reserves. Reserves provide shareholders a view into known, or at least the estimated likely, costs of doing business in the foreseeable future. Example: Our company was sued for selling a defective product that caused injury to a customer. When the lawsuit was received, the company makes an estimate of how much liability it has (in dollar terms), and set that money aside as reserves for when the lawsuit is completed. Once the results of the lawsuit are out, but before the penalties are paid, the reserves are adjusted to reflect the actual amount owed to the plaintiff. Once the payment to the plaintiff is made, the value of the reserve is decreased to $0.
Total liabilities	Total liabilities is simply the sum of all liabilities of a company. This includes total debt, deferred taxes liabilities, minority interest and reserves. Example: Our company has total liabilities = total debt ($16,000) + interest payments ($1,000) + deferred taxes ($0) + minority interest ($5,000) + reserves ($0) = $22,000.
Preferred stock	Preferred stock represents a fractional ownership of a company that has some benefits (and generally, also some downsides) over common stock. On the balance sheet, preferred stock is generally listed as number of outstanding preferred shares, multiply by the par value of each preferred share. The par value is a made up number, usually some round number like $10 or $25, and has no bearing on what price the preferred stock actually trades at. This is mostly an accounting entry, there’s no real point thinking too hard about it. The par value, theoretically, represents the actual value of the share — an investor can return the share to the company and get the par value back. However, the par value is generally so low that no investor would ever do that, so it is mostly an accounting entry.
Common stock	Common stock represents a fractional ownership of a company. In general, stocks traded on the public stock markets are common stock. On the balance sheet, common stock is generally listed as number of outstanding shares, multiply by the par value of each share. The par value is a made up number, generally less than $1, and has no bearing on what price the common stock actually trades at. This is mostly an accounting entry, there’s no real point thinking too hard about it. The par value, theoretically, represents the actual value of the share — an investor can return the share to the company and get the par value back. However, the par value is generally so low that no investor would ever do that, so it is mostly an accounting entry.
Additional paid-in capital	Additional paid-in capital represents the amount investors pay above the par value of preferred or common stock, to the company when they buy shares directly from the company. This is mostly an accounting entry, there’s no real point thinking too hard about it. Remember the par value of shares? The par value of all shares sold + additional paid-in capital will be equal to the total dollar amount of shares that the company sold in a reporting period. It is this total value that is generally interesting, not the individual par value or additional paid-in capital. Example: Our company’s shares are currently trading at $100. However, when our company first IPO’d, it sold 500 shares for $10 a share. The total amount of money raised, which is the important thing we care about, is 500 * $10 = $5,000. For accounting purposes, we break this $5,000 into 2 parts: the common stock value, and the additional paid-in capital. Let’s say the par value of each share is $1 (remember, this is a totally made up number), the common stock value is $500. And therefore, the additional paid-in capital is $5,000 – $500 = $4,500. Notice how these two line items by themselves is mostly useless — it is the total amount of money raised ($5,000) that we generally care about.
Retained earnings	Retained earnings is the amount left over, after net income is used to pay out dividends to shareholders. This, in effect, presents additional investments all shareholders make, to continue the operations of the company. One way to think about this is — a company generates $P in net income in a year. It then distributes all $P to all shareholders as dividends. However, to continue funding the company for the coming year, shareholders are then asked to contribute part of that $P, say $R, back to the company to fund upcoming operations. This $R is retained earnings — companies simply skip the step of asking for $R back, by just reducing dividends by $R directly. Example: Our company had net income of $3,200. It paid no dividends, so retained earnings = net income ($3,200) – dividends ($0) = $3,200.
Unrealized gain/loss	Unrealized gain/loss refers to any gains or losses a company has on securities held for trading, that has not been sold yet. Example: Our company bought 100 shares of another company for $20 a share, total cost basis = $2,000. If those shares appreciated to $30 a share, then our company has an unrealized gain of $(30 – 20) * 100 = $1,000.
Total shareholder equity AKA book value	Total shareholder equity refers to the total equity in a company all shareholders (both preferred and common) have in the company. This is the value of the claim the owners (i.e: shareholders) of a company have, after all debts have been paid. Total shareholder equity = total shareholder equity of previous period + unrealized gain/loss + additional cash infusion from investors + retained earnings. Where additional cash infusion from investors = par value of common and preferred stock issued in new period + additional paid-in capital of new period. Example: For our company, total shareholder equity = total shareholder equity of previous period ($50,000) + unrealized gain/loss ($1,000) + additional cash infusion from investors ($0) + retained earnings ($3,200) = $54,200. Note that total shareholder equity of previous period = $50,000 is made up for this example, and we assume that our company did not issue more shares this period.

Useful quick gauges

Quick ratio	Current liabilities are typically paid out of current assets, which means that a healthy company should usually have current liabilities that are smaller than its current assets. The Quick ratio is generally used as a yardstick to quickly determine how likely a company can meet its short term financial obligations: Quick ratio = (current assets – inventory – prepaid expenses) / current liabilities Note that the numerator is simply those current assets which can be easily sold to raise cash. The lower the Quick ratio, the more likely our company faces a short term cash liquidity crunch. Example: For our company, the Quick ratio = (current assets ($42,500) – inventory ($13,500) – prepaid expenses ($18,000)) / current liabilities ($7,000) = 11,000 / 7,000 = ~1.57. Traditionally, a Quick ratio of 2 is advised — this gives a decent margin of safety against short term issues causing a company financial stress. However, in the modern day, with the advent of “just in time” supply lines, supplier provided short term zero interest debt (via accounts payable), supply chain financing options, standing credit lines, overnight debt markets and generally more liquid debt markets, companies have been known to reduce their cash holdings to increase operating efficiency, while using short term debt to cover potential funding shortfalls. It may sound silly to hold less cash, only to borrow money (and thus pay interest!) to cover funding needs. But, in reality, it may actually increase the profitability of a company. Consider a well run company with high operating margins (say 20%). This company can opt to produce more goods (and thus incur more expenses which draw down its cash reserves). This lets our company earn a likely 20% profit on its cash that is otherwise sitting idle, compared to maybe paying a 1-2% interest rate on overnight funding if the company happens to misjudge its short term funding needs. Since 20% > 1-2%, this is a tradeoff many companies would be happy to make! Be careful though — while many companies are tempted to reduce their cash reserves to improve operating metrics, this should be thought of as increasing leverage — these companies are explicitly leveraging up their balance sheets to improve profits. This is fine and well, but only up to a point. At some point, if the company is constantly running afoul of funding needs, it also then becomes more susceptible to a short term failure to collect on accounts payable, or a short term lull in sales, which may result in the company violating a debt covenant (i.e: miss a required payment) and thus be in default. That can have serious repercussions on the company’s future operations.
Current ratio	The current ratio is very similar to the Quick ratio, and is generally used for similar purposes. The main difference is that the numerator of the Current ratio is just current assets, i.e: Current ratio = current assets / current liabilities Therefore, Current ratio is usually greater than Quick ratio. Different people/sector/industries tend to prefer either Current ratio or Quick ratio over the other. This is mostly a personal preference.
Debt to capital ratio	The debt to capital ratio is a measure of how leveraged a company is. It is computed as Debt to capital ratio = Debt / (Debt + Total shareholder equity) Notice that the denominator is simply the total amount of assets that a company has to operate with, or the total value of everything the company owns. This ratio is analogous to the “loan to value” ratio that most people are familiar with (if you’ve ever taken out a mortgage, the loan to value ratio is simply the amount of mortgage you are taking up, divided by the appraised value of the property). Example: Our company has total debt of $16,000, and total shareholder equity of $54,200. Debt to capital ratio = $16,000 / ($16,000 + $54,200) = ~0.23 = 23%. The higher the debt to capital ratio, the more leveraged a company is. Note that this is an imperfect measure for determining if a company is solvent, or in financial distress! Different sectors/industries have different characteristics. For example, a sector/industry that generally has a lot of steady, positive cash flow will be able to support higher leverage (i.e: higher debt to capital ratios) — because their cash flow is positive and steady (i.e: predictable), there is less need to hold additional cash as a buffer for when cash flow is slow. Comparatively, a company in a sector/industry with very seasonal and/or unpredictable cash flow, will have to hold a much larger cash buffer to be sure that it can pay off its creditors in a timely manner. Because of this, it will naturally be less able to support high debt levels.
Price / Book (P/B) ratio	After we’ve gone through the balance sheet of a company, one thing falls out immediately – the total shareholder equity in the company that shareholders collectively own. If we just take this value, also called “book value”, and then divide it by the number of outstanding shares, we arrive, very neatly, at the book value per share. The P/B ratio is then simply the price per share divided by the book value per share. Looking at the P/B ratio is simply answering the question “how much am I paying for each $1 of net assets in this company?” — a P/B ratio of 2 means you pay $2 for every $1 of net assets on the company’s balance sheet. Example: For our company, the price of each share is $100. The book value is $54,200. Book value per share is thus $54,200 / 1,050 = ~$51.62. Therefore, P/B ratio = 100 / 51.62 = ~1.94 The book value per share of a stock is simply that — the net value of all assets and debt that the the company owns, as represented by a single share of that company. Remember that this does not factor in the usefulness of those assets — certainly a bar of gold is worth a good chunk of change, but a similarly valued piece of machinery is likely more productive(1), which is to say, the machine may be used to generate future profits, while the gold really just sits there, maybe appreciating, maybe depreciating. In that sense, book value per share is generally used as a lower bound for how much a company’s shares are worth — if the company is completely dormant, then the company is just worth the sum of its individual components (i.e: at the lower bound, P/B = 1). However, if the company’s management manages to do something productive with its assets, then the company could be worth much more than just the sum of the components (i.e: P/B > 1). There are, of course, rare cases where management is so inept, that a company is valued at less than book value (i.e: P/B < 1). This tends to happen in one of two cases: When management pursues such value destructive activities, that investors believe the individual components will lose value over time, with no offsetting gain in profits. For example, if a company who’s sole assets are bars of gold, decides that the best way to use its assets is to throw one bar into the ocean every year, then it can be trivially shown that the company would be worth less over time. When there is such uncertainties in the market, or such lack of faith in management, that investors do not believe the reported book value. For example, during the Great Financial Crisis of 2008, banks are regularly valued at below book value, because investors are concerned about potential hidden risks in the assets of banks, as well as potential fraud. As noted, different sectors/industries can leverage their assets in different ways, so the P/B ratio is not directly comparable between sectors and industries. In particular, real estate and manufacturing companies tend to have very low P/B ratios, because they tend to be rich in tangible assets like buildings and machinery (i.e: book value per share, the denominator of the P/B ratio, is high), while software related companies tend to have very high P/B ratios, because they tend to be able to leverage their assets more to generate profits. Generally speaking, if you see 2 companies in the same sector/industry, and they have wildly different P/B ratios, then a good question to ask is, “why is the market valuing the company with lower P/B ratio so poorly?”. Some potential answers: – Investors have little faith in management’s ability to execute. – Investors have little faith in the accounting of the balance sheet. – The company with lower P/B ratio is not leveraging its assets as much as the other company (and so profits are lower per dollar of book value). Depending on the conclusion you arrive at for the question, the difference in P/B ratio may be good (lower leverage implies potential for future profits via higher leverage), or bad (loss of faith in management, or the books).
Return on equity (ROE)	Return on equity tells us how much profit a company is able to generate, with shareholder’s equity in the company. Recall that shareholder’s equity is basically what’s left after all debts of the company is paid off, so this is a measure of financial efficiency — how much profit can this company generate based on how much shareholders have invested in it. Return on equity can be computed using this formula — net income / total shareholder equity Where net income is from the income statement. Example: For our company net income from the income statement is $3,200. Therefore ROE = 3,200 / 54,200 = 5.9%. ROE gives us an idea of how much profits each dollar of shareholder equity generates — in this case, 5.9% of $1, or 5.9c. Note that ROE can be artificially inflated. For example, a loss making company which has a steadily decreasing “retained earnings” that is now negative (i.e: retained losses), will see its equity value deteriorate with time. If at some point, this company is even slightly profitable, the net income divided by the now much diminished equity value, may show a dramatically higher ROE than is reality. Another example is when a company employs excessive debt. Recall that a company can fund itself in many ways, including equity and debt. A company that chooses to primarily fund itself with debt (i.e: higher leverage), will naturally have a higher net income compared to its equity. This gives the false impression of a healthy company, one with high ROE. However, if the company fails to roll over those debt in the future, it’ll likely suffer a catastrophic drop in net income, or may even become insolvent, at least in the short term. It is because of these issues, that I personally eschew ROE, and prefer using ROIC (see next) instead.
Return on invested capital (ROIC)	Like ROE, ROIC gives us an idea of the profitability of a company, and how efficient it is at using the resources at its disposal. Unlike ROE, ROIC takes into account sources of funding the company’s operations other than equity, namely debt. The formula for ROIC is NOPAT / invested capital Where invested capital = total debt + total shareholder equity NOPAT = net operating profit after taxes = operating income * (1 – tax rate) Sometimes, operating income is also called EBIT, which isn’t strictly correct. Recall that EBIT = Earnings before interest and taxes = net income + interest paid + taxes paid Therefore, EBIT includes non-operating expenses and income. That said, non-operating expenses and income should, generally be fairly low compared to operating expenses and income, so EBIT and operating income are generally pretty close. Example: For our company, NOPAT = operating income (5,000) * (1 – tax rate(20%)) = 5,000 * 0.8 = 4,000 Invested capital = total debt (16,000) + total shareholder equity (54,200) = 70,200 Therefore, ROIC = 4,000 / 70,200 = 5.7% Notice how our ROIC is slightly below ROE. This is because there is debt on the company’s balance sheet. ROIC shows us how much profits a company is generating, based on its funding sources, and this is useful in a number of ways: – We can determine how much debt this company can support. Assume a theoretical company with no equity, and that is funded entirely by debt. Then, this company will be able to support debt with interest rates up to around the ROIC. For this theoretical company, if interest rate of debt is below ROIC, then it can “arbitrage” by taking on more debt, and increasing operations — the operations will earn it a return of ROIC, which we already know is greater than the cost of the debt, which is the interest rate we pay on the debt (2). – We can also determine how profitable this enterprise can be. Assume our company is now funded entirely by equity and has no debt. In this case, all the profits flow to the shareholders, and so the shareholders will earn exactly ROIC — if ROIC is 10%, then for every dollar invested, they’ll earn 10c per year. For a well run company, this should be the lower bound. Recall that if our company can get debt at a lower interest rate than ROIC, it can generally produce greater profits by leveraging up and increasing operations. The excess return over the interest paid for debt will then flow to shareholders as well, increasing shareholders’ returns beyond ROIC.

Reading the numbers

The numbers and ratios that we can compute based on the balance sheet generally does not translate directly into a value we should pay for a company. Remember that what a company owns, is not reflective of its potential (or lack thereof!). It is the operations that management layers on top of the company’s assets that generates profits — simply gathering a bunch of factory equipment and putting them together does exactly nothing.

Therefore, except for the special case of a company where operations are to be wound up (e.g: when management is so inept that the best use of the company’s resources is to sell them off and return the cash to shareholders), the balance sheet mostly just tells us how well run a company is, how efficient it is, how profitable is its business, and all of these in terms of the inputs (i.e: funding via equity and debt) into the company.

A well run company will generally have a respectable ROE and ROIC. Generally somewhere in the 10% range is considered pretty good. This is not a hard and fast rule! There are some businesses that are naturally welcoming of leverage, and these tend to have very low ROIC (though potentially very high ROE). For example, most forms of real estate and banking businesses tend to have rather low ROIC because they are so leveraged. In fact, some publishers of company statistics don’t even publish ROIC for banks, because the number is so misleading.

Therefore ROE and ROIC tend to be sector/industry specific — certain sectors/industries just tend to have companies with higher or lower ROE/ROIC.

At the same time, Quick, Current as well as debt to capital ratios give us an idea of how indebted a company is, how likely it is able to service its debts with cash flow, and how likely it is able to meet short term obligations. These are generally useful only on a company by company basis — they tell us how healthy the company is, and how worried we should be of losing our investments in that company.

Finally, the P/B ratio tells us how much we are paying for the company’s assets. It is meaningful only between companies in the same sector/industry, as well as maturity (recall that younger companies tend to have different operating characteristics from more mature ones).

By themselves, none of these metrics are particularly useful for valuing a company. However, they can be used to supplement what we know from the company’s income statement. For example, a company with a particularly high ROE/ROIC for its sector/industry may command a higher P/E (or P/S or whatever) ratio.

Footnotes

1. Notice how this goes back to the investing vs speculating argument — productive assets, used to generate future investment returns vs non-productive assets, used to generate speculative returns.
2. This mathematically true, but not practically true. In practice, whenever a company has more debt on its books, the interest rate lenders will demand will go up sharply. At the same time, every business has a natural limit to how much it can grow. If a business is selling to all the customers it can possibly sell to, then increasing operations will not increase profits. For most companies, it is generally true that as investment in the business goes up, the ROIC will fall — another way of saying this is that the marginal profit from the marginal dollar of investment is a diminishing quantity.