A balance sheet also sometimes referred to as a statement of financial position is a document prepared by an accountant that shows you what a company owns and what it owes.
Companies are required by law to publish their accounts including the balance sheet every year at a minimum but may also publish their accounts every 3 months (US) or 6 months (UK).
This is what Bruce Greenwald, Professor of Finance and Asset Management at Columbia university noted about Graham and Dodd’s most famous work on the balance sheet:
The special importance that Graham and Dodd placed on balance sheet valuations remains one of their most important contributions to the idea of what constitutes a “thorough” analysis of intrinsic value.
In other words, the most celebrated book on value investing places balance sheet valuation as the most important indicator of a listed company’s intrinsic value (the truest value of what a company is actually worth based on what it owns like cash and property and what it owes like bank loans).
Greenwald goes on to state that Graham and Dodd:
…went to balance sheets to determine liquidation values or, as a proxy for these, current assets minus all liabilities….If a company can be bought at a price well below its liquidation value, the it seemed unambiguously a bargain.
Here we can see how Graham and Dodd used the balance sheet to use what they called ‘liquidation value’; a way of determining an extremely conservative intrinsic value for a company.
A company may have cash in the bank (asset) and it might also have taken out bank loans in the past (liability).
A balance sheet will break down all types of assets and liabilities for you and as an investor you can use this published information to try and determine the intrinsic value of a company.
The reason why you’d do this is to try and buy companies below their intrinsic value.
Show Me An Example Of A Balance Sheet
Here is the balance sheet for Apple (NASDAQ: AAPL) dated 28 January 2014 (click here to access your own copy on page 6):
Apple’s Balance Sheet 28 January 2014
I’ve highlighted the first things I look at when I first come across a company’s balance sheet, not just Apple’s, namely the ‘totals’:
- Total current assets
- Total assets
- Total current liabilities
- Total liabilities
- Total shareholders’ equity
The virtues of each of these balance sheet totals is an entire post in itself so for expediency, let’s use Graham and Dodd’s ‘liquidation value’ determination of intrinsic value and apply it to Apple:
- Total Current Assets: $80, 347
- Total Total Liabilities: $95,500
- Liquidation value: $-15,153 – this means that Apple has a negative liquidation value, in other words, its current assets are smaller than it’s total liabilities.
If you were a true value investor following Graham and Dodd’s liquidation value strategy then you would immediately stop your research on Apple and find the next company’s balance sheet to determine its liquidation value.
That is what I do for The Value Investor Report although I use a bespoke version of Graham and Dodd’s original liquidation formula that also includes reading the notes to the accounts for any hidden off balance sheet liabilities and taking into account other assets such as intangibles and PPE where appropriate.
You can see how investing can turn into a numbers game by deftly turning over balance sheet after balance sheet until you find enough stocks to compile a diversified portfolio which is why a lot of people won’t do it and that’s fine by me because not all stocks will have a positive liquidation value and not all stocks that have a positive liquidation value will be selling below their liquidation value.
So the question remains as to whether or not you’d have the stomach to keep on going day after day, week after week looking for bargains or not.
For more on balance sheets including practical examples of valuation techniques see these posts:
- How To Research undervalued Stocks
- The Honest Truth About Ratios And Formulas
- How To Find Undervalued Stocks
- Do You Make This Classic Investing Mistake?
- You Don’t Need To Be Warren Buffett To Understand Goodwill And Intangibles
Image: Balance 3