Is it cheap enough? Is its balance sheet strong enough?

The Market Price-to-Book and Intrinsic Price-to-Book Ratio

The balance sheet equation corresponds to the value equation. 

 

The value equation can be written as:

 

Value of the firm = Value of equity + Value of debt
or
Value of equity = Value of firm - Value of debt

 

• The value of the firm is the value of the firm's assets and its investments.
•  The value of the debt is the value of the liability claims.

 

The value equation and the balance sheet equation are of the same form but differ in how the assets, liabilities, and equity are measured.

 

The measure of stockholders' equity on the balance sheet,l the book value of equity, typically does not give the intrinsic value of what the equity is worth. 

• Correspondingly, the net assets are not measured at their values. 
• If they were, there would be no analysis to do!  It is because the accountant does not, or cannot, calculate the intrinsic value that fundamental analysis is required.

The diffeence between the intrinsic value of equity and its book value is called the intrinsic premium:

 

Intrinsic premium = Intrinsic value of equity - Book value of equity

 

The difference between the market price of equity and its book value is called the market premium:

 

Market premium = Market price of equity - Book value of equity

 

If these premiums are negative, they are called discounts (from book value).  Premiums sometimes are referred to as unrecorded goodwill because someone purchasing the firm at a price greater than book value could record the premium paid as an asset, purchased goodwill, on the balance sheet; without a purchase of the firm, the premium is unrecorded.

 

Premiums can be calculated for the total equity or on a per-share basis.

 

-----

 

Example:
Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

 

Comments: 
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

-----

 

 

The ratio of market price to book value is the price-to-book ratio or the market-to-book ratio.

 

The ratio of intrinsic value to book value is the intrinsic price-to-book ratio. 

 

• Investors talk of buying a firm for a number of times book value, referring to the P/B ratio. 
• The market P/B ratio is the multiple of book value at the current market price. 
• The intrinsic P/B ratio is the multiple of book value that the equation is worth. 
• An investor will spend considerable time estimating intrinsic price-to-book ratios and asking if those intrinsic ratios indicate the the market P/B is mispriced.

Historical Perspective of P/B ratios

 

In asking such questions, it is important to have a sense of history so that any calculation can be judged against what was normal in the past.  The history provides a benchmark for our analysis.  

• P/B ratios in the 1990s were high relative to historical averages, indicating that the stock market was overvalued.  
• The medican P/B ratios (the 50th percentile) for the U.S. listed firms were indeed high in the 1990s - over 2.0 - relative to the 1970s. 
• But they were around 2.0 in the 1960s. 
• The 1970s experienced exceptionally low P/B ratios, with medians below 1.0 in some years.

 

What causes the variation in ratios? 

• Is it due to mispricing in the stock market?
• Is it due to the way accountants calculate book values?

 

The low P/B ratios in the 1970s certainly preceded a long bull market.

• Could this bull market have been forecast in 1974 by an analysis of intrinsic P/B ratios?
• Were market P/B ratios in 1974 too low? 
• Would an analysis of intrinsic P/B ratios in the 1990s find that they were too high?

 

Company A's P/B of 11.0 in 2008 looks high relative to historical averages.

• Was it too high?

 

The fundamental investor sees himself as providing answers to these questions.  He estimates the intrinsic value of equity that is not recorded on the balance sheet. 

 

You can screen for firms with particular levels of P/B ratios using stock screener from links on the Web.

How to value this stock?

Wednesday June 24, 2009
John Master’s ‘retirement’ an eye-opener
Comment by Jagdev Singh Sidhu



THE circumstances in which a company proposes to sell its assets, distribute all the cash to shareholders and eventually remove itself from the stock exchange are usually done when conditions are dire.

It’s either that the company is financially haemorrhaging or affected by some cataclysmic event that has destroyed its balance sheet.

Rarely would that scenario be pictured of a still healthy albeit marginally profitable listed company that has basically decided to call it a day on the stock exchange.

When John Master Industries Bhd (JMI) said it wanted to “retire” as a listed company, the motive itself was a little perplexing. In its latest annual report, John Master did not sound like it was preparing to throw in the towel. Nor did it indicate such a desire in its latest quarterly announcement.

Yes, low trading volumes are an indication of investor interest and JMI said its average trading volume of just 7,300 shares a day over the past 12 months shows how illiquid and thinly traded its stock is.

Meagre volumes might be a reflection of investor interest but is that sufficient reason to exit the exchange? Based on yesterday’s trading on Bursa Malaysia, there were 317 companies on the stock exchange with fewer shares traded.

Financially, JMI has hinted that it was treading on water. It says its financial future is uncertain and the prospects for the industry it operates in are tough.

Competition in this business is fierce and there will always be places where it’s cheaper to produce a piece of garment than Malaysia. Economics and profitability will rule and the directors might feel that the company is fighting a losing battle on that front.

It argues those conditions make any future dividend payments doubtful. Even though business conditions are tough and outlook uncertain, there is an offer to bid for the assets of JMI from three directors of the company related to the founder of the company who retired in May last year.

Nobody knows whether shareholders would get full value of the company’s net tangible assets which was RM1.07. The company’s last traded share price was 49 sen a share.

The company is relatively debt free with only RM5.5mil in short-term borrowings. It has RM43mil in cash, or a cash backing of 35 sen a share.

Most of its assets are in the form of inventories (RM67mil) and receivables (RM39.7mil). Plant and machinery carries a value of RM2.8mil on the balance sheet and land for development is another RM2.4mil.

The company, however, has promised that its assets would be sold via an open tender and under the watchful eye of Ferrier Hodgson MH Sdn Bhd.

Cashing out of JMI would give shareholders of the company the financial flexibility to decide on what to do with their money. It’s also an avenue for shareholders to maybe realise the value of their current investment in a thinly traded counter with over 122 million shares.

The entire exercise might be a quasi privatisation process of JMI but whatever it is, the entire exercise would be a test case for other companies on Bursa.

It’s for the directors, who act as custodians of a company, to advice and recommend the best course of action to be taken by a company. And in this case, they have decided that the latest proposal is in the best interest of the listed company.


Ultimately it will be a decision for the company’s shareholders to make.


JMI : [Stock Watch] [News]


http://biz.thestar.com.my/news/story.asp?file=/2009/6/24/business/4182449&sec=business


Ref: Asset valuation approach in liquidation


Company Name: JOHN MASTER INDUSTRIES BERHAD
Stock Name: JMI
Date Announced: 29/05/2009
Financial Year End: 31/03/2009
Quarter: 4
Announce - 0309(Ann).xls
Announce - 0309 (Ann).doc

When valuing a business for liquidation, most assets are marked down and the liabilities treated at face value.

• Cash and securities are taken at face value.
  
• Receivables require a small discount (perhaps 15 percent to 25 percent off).
  
• Inventory a larger discount (perhaps 50 percent to 75 percent off).
  
• Fixed assets at least as much as inventory.
  
• Any goodwill should probably be ignored.
  
• Most intangible assets and prepaid expenses should be ignored.

Applying the following to the latest balance sheet of JMI:

• a 50% discount to fixed assets and inventories,
• 25% discount to receivables, and
• all liabilities are at face value,

I deduced a liquidation NTA value of $ 0.70 per share (equivalent to net worth for the whole company of $ 110.5 m).

http://spreadsheets.google.com/pub?key=rMg4CdEMPdLx-jOwZM-ecKA&output=html

This contrast with the reported NTA of $ 1.0754 per share in its latest quarterly report.

Today, the market price per share of JMI is $ 0.60 giving a market capitalization of $ 73.70 m. Therefore there is little potential upside here.

Reading a Balance Sheet

Reading a Balance Sheet

A balance sheet will tell us something about the financial strength of a business on the day that the balance sheet is drawn up.

This action list gives an overview of a balance sheet and looks at a brief selection of the more interesting figures that help with interpretation. It is important to remember that a lot of these figures do not tell you that much in isolation; it is in trend analysis or comparisons between businesses that they talk more lucidly.

What is a balance sheet?

A balance sheet is an accountant's view, the book value of the assets and liabilities of a business at a specific date and on that date alone. By balancing the assets and liabilities and showing how the balance lies, it gives us an idea of the financial health of the business.

What does a balance sheet not do?

A balance sheet is not designed to represent market value of the business. For example, property in the balance asset may be worth a lot more than its book value. Plant and machinery is shown at cost less depreciation, but that may well be different from market value. Stock may turn out to be worth less than its balance sheet value, and so on.

Also, there may be hidden assets, such as goodwill or valuable brands, that do not appear on the balance sheet at all. These would all enhance the value of the business in a sale situation, yet are invisible on a normal balance sheet.

Learn to interpret the balance sheet

Note that the balance sheets differ between one industy and another as regards the range and type of assets and liabilities that exist. For example, a retailer will have little in the way of trade debtors because it sells for cash, while a manufacturer is likely to have a far larger investment in plant than a service business like an advertising agency. So the interpretation must be seen in the light of the actual trade of the business.

Reading a balance sheet can be quite subjective - accountancy is an art, not a science and, although the method of producing a balance sheet is standardized, there may be some items in it that are subjective rather than factual. The way people interprete some of the figures will also vary, depending on what they wish to achieve and how they see certain things as being good or bad.

Look first at the net assets/shareholders' funds

Positive or negative? Positive is good.

If it had negative assets (same thing as net liabilities, this might mean that the business is heading for difficulty unless it is being supported by some party such as a parent company, bank, or other investor. When reading a balance sheet with negative assets, consider where the support will be coming from.

Then examine net current assets

Positive or negative? Positive net current assets (NCA) mean that, theoretically, it should not have any trouble settling short-term liabilities because it has more than enough current assets to do so. Negative net current assets suggest that there possibly could be a problem in settling short-term liabilities.

You can also look at NCA as a ratio of current assets/current liabilities. Here, a figure over one is equivalent to the NCA having a positive absolute figure. The ratio version is more useful in analysing trends of balance sheets over successive periods or comparing two businesses.

A cut-down version of NCA considers only (debtors + cash)/(creditors) thus excluding stock (Quick Ratio). The reasoning here is that this looks at the most liquid of the net current asset constituents. Again a figure over one is the most desirable. This is also a ratio that is more meaningful in trends or comparisons.

Understand the significance of trade debtor payments...

Within current assets, we have trade debtors. It can be useful to consider how many days' worth of sales are tied up in debtors - given by (debtors x 365)/annual sales. This provides an idea of how long the company is waiting to get paid. Too long and it might be something requiring investigation. However, this figure can be misleading where sales do not take place evenly throughout the year. A construction company might be an example of such a business: one big debtor incurred near the year end would skew the ratio.

...and trade creditor payments.

Similar to the above, this looks at (trade creditors x 365)/annual purchases, indicating how long the company is taking in general to pay its suppliers. This is not so easy to calculate, because the purchases for this purpose include not only goods for resale but all the overheads as well.


Recognise what debt means

Important to most businesses, this figure is the total of long and short-term loans. Too much debt might indicate that the company would have trouble, in a downturn, in paying the interest. It's difficult to give an optimum level of debt because there are so many different situations, depending on a huge range of circumstances.

Often, instead of an absolute figure, debt is expressed as a percentage of shareholder's funds and known as 'gearing' or 'leverage'. In a public company, gearing of 100% might be considered pretty high, whereas debt of under 30% may be seen as on the low side.

COMMON MISTAKES

Believing that balance sheet figures represent market value

Don't assume that a balance sheet is a valuation of the business. Its primary purpose is that it forms part of the range of accounting reports used for measuring business performance - along with the other common financial reports like profit and loss accounts and cash-flow statements. Management, shareholders, and others such as banks will use the entire range to assess the health of the business.

Forgetting that the balance sheet is valid only for the date at which it is produced

A short while after a balance sheet is produced, things could be quite different. In practice there frequently may not be any radical changes between the date of the balance sheet and the date when it is being read, but it is entirely possible that something could have happended to the business that would not show. For example, a major debtor could have defaulted unexpectedly. So remember that balance sheet figures are valid only as at the date shown, and are not a permanent picture of the business.

Confusion over whether in fact all assets and liabilities are shown in the balance sheet

Some businesses may have hidden assets, as suggested above. This could be the value of certain brands or trademarks, for example, for which money may not have ever been paid. Yet these could be worth a great deal. Conversely, there may be some substantial legal action pending which could cost the company a lot, yet is not shown fully in the balance sheet.


Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)

Introduction to financial statements

Learn about stocks


Stocks 107: Introduction to financial statements


You don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: The income statement, the balance sheet, and the statement of cash flows.


[Related content: stocks, stock market, investments, investing strategy, bonds]


By Morningstar.com


Although the words "financial statements" and "accounting" send cold shivers down many people's backs, this is the language of business, a language investors need to know before buying stocks. The beauty is you don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: the income statement, the balance sheet, and the statement of cash flows. All three of these statements are found in a firm's annual report, 10-K, and 10-Q filings.


The financial statements are windows into a company's performance and health. We'll provide a very basic overview of each financial statement in this lesson and go into much greater detail in Lessons 301-303.


Morningstar.com's Investing Classroom


The income statement



The income statement tells you how much money a company has brought in (its revenues), how much it has spent (its expenses), and the difference between the two (its profit or loss). It shows a company's revenues and expenses over a specific time frame such as three months or a year. This statement contains the information you'll most often see mentioned in the press or in financial reports -- figures such as total revenue, net income or earnings per share.


The income statement answers the question, "How well is the company's business performing?" Or in simpler terms, "Is it making money?" A company must be able to bring in more money than it spends or it won't be in business for very long. Companies with low expenses relative to revenues -- and thus, high profits relative to revenues -- are particularly desirable for investment because a bigger piece of each dollar the company brings in directly benefits you as a shareholder.


Each of the three main elements of the income statement is described below.


Revenues. The revenue section is typically the simplest part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenues in ways that provide more information (for instance, segregated by geographic location or business segment). Revenues are also commonly known as sales.


More from MSN Money and Morningstar
Stocks 108: Learn the lingo – basic ratios
Stocks 101: Stocks versus other investments
Stocks 102: The magic of compounding
Stocks 103: Investing for the long run
MSN Money's New Investor Center



Expenses. Although there are many types of expenses, the two most common are the cost of sales and SG&A (selling, general and administrative) expenses. Cost of sales, which is also called cost of goods sold, is the expense most directly involved in creating revenue. For example, Gap (GPS, news, msgs) may pay $10 to make a shirt, which it sells for $15. When it is sold, the cost of sales for that shirt would be $10 -- what it cost Gap to produce the shirt for sale. Selling, general, and administrative expenses are also commonly known as operating expenses. This category includes most other costs in running a business, including marketing, management salaries, and technology expenses.


Profits. In its simplest form, profit is equal to total revenues minus total expenses. However, there are several commonly used profit subcategories investors should be aware of. Gross profit is calculated as revenues minus cost of sales. It basically shows how much money is left over to pay for operating expenses (and hopefully provide profit to stockholders) after a sale is made.



Using our example of the Gap shirt before, the gross profit from the sale of the shirt would have been $5 ($15 sales price - $10 cost of sales = $5 gross profit). Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings."


The balance sheet



The balance sheet, also known as the statement of financial condition, basically tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets," "stockholders' equity," or "net worth."
More investing courses from Morningstar


The balance sheet provides investors with a snapshot of a company's health as of the date provided on the financial statement. Generally, if a company has lots of assets relative to liabilities, it's in good shape. Conversely, just as you would be cautious loaning money to a friend who is burdened with large debts, a company with a large amount of liabilities relative to assets should be scrutinized more carefully.


Each of the three primary elements of the balance sheet is described below.


Assets. There are two main types of assets: current assets and noncurrent assets. Within these two categories, there are numerous subcategories, many of which will be explained in Lesson 302. Current assets are likely to be used up or converted into cash within one business cycle -- usually defined as one year. For example, the groceries at your local supermarket would be classified as current assets because apples and bananas should be sold within the next year. Noncurrent assets are defined by our left-brained accountant friends as, you guessed it, anything not classified as a current asset. For example, the refrigerators at your supermarket would be classified as noncurrent assets because it's unlikely they will be "used up" or converted to cash within a year.



Liabilities. Similar to assets, there are two main categories of liabilities: current liabilities and noncurrent liabilities. Current liabilities are obligations the company must pay within a year. For example, your supermarket may have bought and received $1,000 worth of eggs from a local farm but won't pay for them until next month. Noncurrent liabilities are the flip side of noncurrent assets. These liabilities represent money the company owes one year or more in the future. For example, the grocer may borrow $1 million from a bank for a new store, which it must pay back in five years.


Equity. Equity represents the part of the company that is owned by shareholders; thus, it's commonly referred to as shareholders' equity. As described above, equity is equal to total assets minus total liabilities. Although there are several categories within equity, the two biggest are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares. Retained earnings represent the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated deficit."


The statement of cash flows



The statement of cash flows tells you how much cash went into and out of a company during a specific time frame such as a quarter or a year. You may wonder why there's a need for such a statement because it sounds very similar to the income statement, which shows how much revenue came in and how many expenses went out.


The difference lies in a complex concept called accrual accounting. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. While that explanation seems simple enough, it's a big mess in practice, and the statement of cash flows helps investors sort it out.


More from MSN Money and Morningstar
Stocks 108: Learn the lingo – basic ratios
Stocks 101: Stocks versus other investments
Stocks 102: The magic of compounding
Stocks 103: Investing for the long run
MSN Money's New Investor Center



The statement of cash flows is very important to investors because it shows how much actual cash a company has generated. The income statement, on the other hand, often includes noncash revenues or expenses, which the statement of cash flows excludes.


One of the most important traits you should seek in a potential investment is the company's ability to generate cash. Many companies have shown profits on the income statement but stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies may have warned investors that rocky times were ahead.


Because companies can generate and use cash in several different ways, the statement of cash flows is separated into three sections: cash flows from operating activities, from investing activities and from financing activities.


The cash flows from operating activities section shows how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. Investors should look closely at how much cash a company generates from its operating activities because it paints the best picture of how well the business is producing cash that will ultimately benefit shareholders.


The cash flows from investing activities section shows the amount of cash firms spent on investments. Investments are usually classified as either capital expenditures -- money spent on items such as new equipment or anything else needed to keep the business running -- or monetary investments such as the purchase or sale of money market funds.


The cash flows from financing activities section includes any activities involved in transactions with the company's owners or debtors. For example, cash proceeds from new debt, or dividends paid to investors would be found in this section.


Free cash flow is a term you will become very familiar with over the course of these lessons. In simple terms, it represents the amount of excess cash a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations; thus, it's considered "free." Although there are many methods of determining free cash flow, the most common method is taking the net cash flows provided by operating activities and subtracting capital expenditures (as found in the "cash flows from investing activities" section).
Cash from Operations - Capital Expenditures = Free Cash Flow


The bottom line



Phew!!!



You made it through an entire lesson about financial statements. While we're the first to acknowledge that there are far more exciting aspects of investing in stocks than learning about accounting and financial statements, it's essential for investors to know the language of business. We also recommend you sharpen your newfound language skills by taking a good look at the more-detailed discussion on financial statements in Lessons 301-303.

Balance Sheet Value: Assets at Work

Balance Sheet Value: Assets at Work

Pure value investing starts with the balance sheet, the list of assets and liabilities, and the resulting difference called book value.

The following metrics can be derived:
· Net-net working capital
· Net asset value
· Liquidation value, and
· Reproduction cost

In some areas, our economic environment has outpaced our accounting principles so that sizable asset classes called intangibles bearing large values remain unrecorded on the asset side of a balance sheet.

Examples are:
· Intellectual property (copyrights, patents, and trademarks), and
· Human capital (a well-trained workforce, know-how, and specialized skill sets).


Also read:
1.Balance Sheet Value: Assets at Work
2.Reliability of financial data
3.Asset valuation approach in liquidation
4.Asset valuation approaches in active companies
5.Valuing Hidden assets
6.Subtracting liabilities in asset valuation
7.Balance Sheet Value: Summary

Book Value (Net Asset Value)

Synonyms:
Net asset value
Book value
Balance sheet value
Tangible-asset value
Net worth

= Total value of a company's physical and financial assets minus all its liabilities.

It can be calculated using the balance sheets in a company's annual and quarterly reprots.

From total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles.

Divide by the fully diluted number of shares outstanding to arrive at book value per share.