How to Invest in Stocks: What to Look for When Evaluating Companies
The balance sheet tells you the amount of a business’s assets, such as cash, investments it holds, as well as items such as receivables – money it needs to receive from customers. It also tells you how much debt the business has. The “balance” of the balance sheet is the comparison of assets to liabilities.
A few very important aspects of a business can be learned from the balance sheet. The first is the Current ratioalso known as working capital ratio. Working capital is the money a business has to cover its obligations. It’s an exercise in asking, If a business stopped making money today, would it have enough assets to cover what it has to pay? A company with a higher general liquidity ratio has a stronger balance sheet and is better able to cover its obligations.
The current ratio is calculated by dividing current assets by current liabilities. Among the highest current ratios of any S&P 500 company is homebuilder DR Horton (DHI; $72.86). It has a current ratio of 4.9. This makes sense, given that Horton has a lot of value in short-term assets locked up in what’s called inventory, things like construction in progress and land, both developed and undeveloped. These are assets that help offset its obligation to deliver homes.
In contrast, a company such as the Dollar General discount chain (CEO; $248.73) has one of the lowest current ratios, at about one times current assets to current liabilities. Dollar General has very little cash, with most of its assets being merchandise that it holds in its stores. At the same time, he owes a large sum over a period of time to the suppliers of his goods, and the two things pretty much cancel each other out. You might conclude that Dollar General operates with a lot less cushion than Horton.
Another important balance sheet finding is what is known as the enterprise value. Do you remember our market capitalization that we mentioned above? It’s normally used as the total value of a company if you add up all of its shares. But if a company has a lot of cash or a lot of debt, you’ll need to adjust the market capitalization to reflect that.
A company with lots of cash is cheaper than its stock price suggests because you get a share of that big pile of cash with every stock you buy. Conversely, a highly leveraged company will be more expensive than the stock price suggests, because you take responsibility for that debt with every stock you buy.
To find the value of the company, take the market capitalization and subtract the dollar amounts for cash, and to add dollar rises to debt. Take DR Horton again as an example. At the end of July, the company had a market cap of $25 billion. But because it has more debt than cash — $4.26 billion versus $1.68 billion — its enterprise value, at $27.8 billion, is more than $2 billion higher. to its market capitalization of $25 billion. Horton is more expensive when you calculate enterprise value.
Dollar General, with considerably more debt than cash, has an even bigger gap between its market capitalization and its enterprise value – it’s a lot more expensive on the latter basis than you would think just by checking the course of the action.
Enterprise value adds sophistication to valuation analysis in other ways. Remember our P&L price-to-sales and price-to-earnings ratios? An investor who wants to be more sophisticated than average will look beyond these two measures. They will take the enterprise value and use that number instead of the market capitalization to divide by sales or by profit. The ratio is no longer price-to-sales, it is now”EV to sales” Where “EV to profit.” You can also combine enterprise value with our discussion of free cash flow from the cash flow statement, and arrive at “free EV-cash-flow“, and be really sophisticated.
For example, Apple, you’ll recall, has a P/E of 30, more expensive than its S&P 500 brethren. But, with nearly $179 billion in cash and investments, Apple has more money than the most entities on the planet. If you want to get really sophisticated, you’ll take Apple’s enterprise value, which takes that money into account, and divide it by the company’s last 12 months of free cash flow. On that basis, Apple has an EV-to-free-cash-flow of 25 – still more expensive than the S&P, but not as much as it looked based on a direct P/E.
That way, if someone tells you something looks cheap, you might want to ask what it looks like when EV is used, to reflect if cash or debt affects the valuation.