Navigating the balance sheet to chart a firm’s real value
Crisis makes it crucial to know a company’s intrinsic worth
Stephen Vines 10 May 2009
If the financial crisis has taught us anything, it is that investors need to pay attention to the intrinsic value of companies.
Yet Hong Kong shareholders invariably focus on such things as price-earnings ratios or yields, both of which are important but mainly tell you how companies are performing relative to their share price, in other words, relative to the market’s view of their worth.
More cumbersome, but ultimately more rewarding, is a study of company balance sheets. However, balance sheets are like politicians - they are very tricky and tend to obscure more than they reveal. Moreover, they are essentially a snapshot of a company’s affairs on a given day.
As such, these accounts can be massaged to appear in healthy shape on that day by such means as booking sales in advance or fiddling with depreciation figures, etc. Some companies have a habit of excessive massaging, but over time their balance sheets remain the key to understanding what they are doing.
So as we come to the end of the reporting season, sitting on a pile of freshly minted company reports, let’s see how we can make use of them.
The trick in reading balance sheets is to look at the areas where companies bury the embarrassing bodies, where they park the bad news and dress it up as good news, and where little time bombs are found ticking.
What follows is a quick guide to where to look when trying to discover the true state of a company’s affairs. It is not a definitive guide and hardly infallible because as soon as one crafty way of hiding embarrassing information is exposed, new and more ingenious ways come to light.
Turnover
Starting at the beginning with the seemingly straightforward matter of a company’s turnover, it is essential to look at the notes which detail how that turnover was achieved.
In Hong Kong, many companies do not adequately separate recurrent income - derived from their core business - from turnover achieved by one-off sales of assets, such as property.
It is necessary to strip out these non-recurrent items to learn about the health of the core businesses. Also, pay attention to companies that engage in extensive related-party transactions (these are shown separately in the notes) because it is often hard to discover how these transactions are priced, especially when the transaction involves the listed company and the private companies controlled by the majority shareholders.
Among major markets, Hong Kong is unusual in having such a small percentage of a company’s equity in the public domain, with the rest being held by majority shareholders who are often not averse to shuffling assets and costs between their privately held entities and the public companies. No genius is required to work out who wins in these circumstances.
EBITDA
Be very wary of any company that bangs on about EBITDA, or earnings before interest, taxes, depreciation and amortisation. This term has been around for some time but sprung to prominence in the era of dotcom madness when high-flying tech companies had impressive stock market valuations but were earning peanuts.
It was suggested that EBITDA gave a better picture of a company’s true performance because it stripped out all costs not directly related to trading. However, costs are costs and any company pretending that some costs can be ignored while others need to be taken into consideration is simply finding a way of explaining why profits are so low.
Cash
This basically means liquid investments with maturity in no more than three months. Some companies are known for being cash-rich, which sounds very good - and in many cases is very good - but may mean they are managing assets badly because pouring cash into low-yielding financial instruments as opposed to putting it effectively to work by investing in the business or buying other businesses can mean loss of opportunity.
It may even be that a large proportion of this cash is borrowed, and if it is just sitting there and is subject to heavy repayment liabilities, it is definitely not a good thing.
It is therefore worth checking if a company habitually keeps a lot of cash. The five-year record in the annual report will show whether this is so. If this is the case, it may simply mean the management has little idea about how to grow the business.
Dividends
In some places investors pay a lot of attention to dividend payments. This is less the case in Hong Kong, where smaller shareholders tend to be traders and are anxious to secure capital gains as opposed to modest investment growth from dividends.
However, dividends tend to be of great interest to majority shareholders who pay themselves relatively modest salaries because they are subject to tax, preferring to take their real income from dividends, which are tax-free. Therefore, although high dividends are often welcome, companies that regularly pay out a high percentage of their earnings in dividends need to be examined carefully to see whether they are leaving enough cash in the business for future investment.
Assets
Naturally shareholders want to know how much their companies are worth and so they head down to the column which states: total assets less liabilities. If a negative asset figure appears at this stage, something is clearly amiss.
However, even if more assets than liabilities are shown, this may not tell the whole story because all assets are not equal and some items listed as assets may be worthless.
What investors need to know first of all is the true value of the capital assets, such as buildings and machinery. If they are not revalued on an annual basis, as they should be according to best practice, the valuation on these assets might have little relationship to their real worth.
In the short term, companies will list assets such as amounts due. This can make up a large part of their asset base and if it is a large figure relative to total assets, it often suggests that some of this money will never be paid. A simple division of money owed over sales will show the percentage of sales that have not been paid for. As soon as this runs into double digits, warning signs should be flashing.
Then there are companies that list impressive figures for “goodwill” (meaning the excess value of a business over the value of tangible assets, a truly moveable feast). And companies not satisfied with inflating their asset value this way just love throwing in intangibles, which, as the name suggests, lists hard-to-value assets such as trademarks and customer base. As a broad rule of thumb, any company that relies on these items to make up a large proportion of its asset base is unlikely to be giving an accurate picture of its asset worth.
Over on the liabilities side of the equation, high borrowings are not necessarily a bad thing, especially when a company is expanding fast and is able to borrow on favourable terms. Sometimes this means they have borrowed at below current rates or even below rates of return on secure investments such as bank deposits (well, they used to be secure before banks started to collapse).
The better companies tell you the cost of their borrowings, give a clear picture of when repayment is due and show the percentage of borrowings that have had to be rescheduled.
Provisioning
This has become a hot topic in the economic crisis, where companies in the financial sector were shown to have made insufficient provision for bad debts. But they were not alone as other companies have to take a view on what is going to happen in the future.
Some make excessive provisions in good years to deflate their bottom-line figure so that they can release sums from the provisions when profits are not so hot. It is hard to judge whether provisions are adequate or exaggerated, but looking at the five-year record helps to identify whether or not this moveable feast is serving shareholders’ interests.
Beyond the numbers
The meat of any annual report is obviously the statistical data but the alert investor will pay careful attention to a number of other indicators, such as these:
Qualified auditors report
By and large, Hong Kong auditors are loath to publicly state reservations about listed companies’ balance sheets. If they do so, something is amiss.
Majority shareholders’ trading
Aside from the controversy over whether there needs to be an extended period in which insiders are prohibited from trading the shares of their companies, it is safe to say that majority shareholders who are consistently fiddling with their own company shareholdings are likely to have their eye off the ball. In the best companies, the major shareholders focus on running the business, not adjusting their shareholdings.
Derivative financial investments
Companies must disclose their trading in these instruments. Be very scared of any corporation that has heavy derivative investments. Many have imploded in recent months but even in better times, it tells investors that the directors have a casino mentality, which is not conducive to sound business.
Annual General Meetings
AGMs tend to be short in Hong Kong. But investors are perfectly entitled to use these events as a unique opportunity to question their directors. Be very aware of companies that hold AGMs at the kind of speed which precludes questioning. The better companies not only encourage questions but use AGMs as an opportunity to describe the company’s strategy and operations.
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Navigating the balance sheet to chart a firm’s real value
Crisis makes it crucial to know a company’s intrinsic worth
Stephen Vines
10 May 2009
If the financial crisis has taught us anything, it is that investors need to pay attention to the intrinsic value of companies.
Yet Hong Kong shareholders invariably focus on such things as price-earnings ratios or yields, both of which are important but mainly tell you how companies are performing relative to their share price, in other words, relative to the market’s view of their worth.
More cumbersome, but ultimately more rewarding, is a study of company balance sheets. However, balance sheets are like politicians - they are very tricky and tend to obscure more than they reveal. Moreover, they are essentially a snapshot of a company’s affairs on a given day.
As such, these accounts can be massaged to appear in healthy shape on that day by such means as booking sales in advance or fiddling with depreciation figures, etc. Some companies have a habit of excessive massaging, but over time their balance sheets remain the key to understanding what they are doing.
So as we come to the end of the reporting season, sitting on a pile of freshly minted company reports, let’s see how we can make use of them.
The trick in reading balance sheets is to look at the areas where companies bury the embarrassing bodies, where they park the bad news and dress it up as good news, and where little time bombs are found ticking.
What follows is a quick guide to where to look when trying to discover the true state of a company’s affairs. It is not a definitive guide and hardly infallible because as soon as one crafty way of hiding embarrassing information is exposed, new and more ingenious ways come to light.
Turnover
Starting at the beginning with the seemingly straightforward matter of a company’s turnover, it is essential to look at the notes which detail how that turnover was achieved.
In Hong Kong, many companies do not adequately separate recurrent income - derived from their core business - from turnover achieved by one-off sales of assets, such as property.
It is necessary to strip out these non-recurrent items to learn about the health of the core businesses. Also, pay attention to companies that engage in extensive related-party transactions (these are shown separately in the notes) because it is often hard to discover how these transactions are priced, especially when the transaction involves the listed company and the private companies controlled by the majority shareholders.
Among major markets, Hong Kong is unusual in having such a small percentage of a company’s equity in the public domain, with the rest being held by majority shareholders who are often not averse to shuffling assets and costs between their privately held entities and the public companies. No genius is required to work out who wins in these circumstances.
EBITDA
Be very wary of any company that bangs on about EBITDA, or earnings before interest, taxes, depreciation and amortisation. This term has been around for some time but sprung to prominence in the era of dotcom madness when high-flying tech companies had impressive stock market valuations but were earning peanuts.
It was suggested that EBITDA gave a better picture of a company’s true performance because it stripped out all costs not directly related to trading. However, costs are costs and any company pretending that some costs can be ignored while others need to be taken into consideration is simply finding a way of explaining why profits are so low.
Cash
This basically means liquid investments with maturity in no more than three months. Some companies are known for being cash-rich, which sounds very good - and in many cases is very good - but may mean they are managing assets badly because pouring cash into low-yielding financial instruments as opposed to putting it effectively to work by investing in the business or buying other businesses can mean loss of opportunity.
It may even be that a large proportion of this cash is borrowed, and if it is just sitting there and is subject to heavy repayment liabilities, it is definitely not a good thing.
It is therefore worth checking if a company habitually keeps a lot of cash. The five-year record in the annual report will show whether this is so. If this is the case, it may simply mean the management has little idea about how to grow the business.
Dividends
In some places investors pay a lot of attention to dividend payments. This is less the case in Hong Kong, where smaller shareholders tend to be traders and are anxious to secure capital gains as opposed to modest investment growth from dividends.
However, dividends tend to be of great interest to majority shareholders who pay themselves relatively modest salaries because they are subject to tax, preferring to take their real income from dividends, which are tax-free. Therefore, although high dividends are often welcome, companies that regularly pay out a high percentage of their earnings in dividends need to be examined carefully to see whether they are leaving enough cash in the business for future investment.
Assets
Naturally shareholders want to know how much their companies are worth and so they head down to the column which states: total assets less liabilities. If a negative asset figure appears at this stage, something is clearly amiss.
However, even if more assets than liabilities are shown, this may not tell the whole story because all assets are not equal and some items listed as assets may be worthless.
What investors need to know first of all is the true value of the capital assets, such as buildings and machinery. If they are not revalued on an annual basis, as they should be according to best practice, the valuation on these assets might have little relationship to their real worth.
In the short term, companies will list assets such as amounts due. This can make up a large part of their asset base and if it is a large figure relative to total assets, it often suggests that some of this money will never be paid. A simple division of money owed over sales will show the percentage of sales that have not been paid for. As soon as this runs into double digits, warning signs should be flashing.
Then there are companies that list impressive figures for “goodwill” (meaning the excess value of a business over the value of tangible assets, a truly moveable feast). And companies not satisfied with inflating their asset value this way just love throwing in intangibles, which, as the name suggests, lists hard-to-value assets such as trademarks and customer base. As a broad rule of thumb, any company that relies on these items to make up a large proportion of its asset base is unlikely to be giving an accurate picture of its asset worth.
Over on the liabilities side of the equation, high borrowings are not necessarily a bad thing, especially when a company is expanding fast and is able to borrow on favourable terms. Sometimes this means they have borrowed at below current rates or even below rates of return on secure investments such as bank deposits (well, they used to be secure before banks started to collapse).
The better companies tell you the cost of their borrowings, give a clear picture of when repayment is due and show the percentage of borrowings that have had to be rescheduled.
Provisioning
This has become a hot topic in the economic crisis, where companies in the financial sector were shown to have made insufficient provision for bad debts. But they were not alone as other companies have to take a view on what is going to happen in the future.
Some make excessive provisions in good years to deflate their bottom-line figure so that they can release sums from the provisions when profits are not so hot. It is hard to judge whether provisions are adequate or exaggerated, but looking at the five-year record helps to identify whether or not this moveable feast is serving shareholders’ interests.
Beyond the numbers
The meat of any annual report is obviously the statistical data but the alert investor will pay careful attention to a number of other indicators, such as these:
Qualified auditors report
By and large, Hong Kong auditors are loath to publicly state reservations about listed companies’ balance sheets. If they do so, something is amiss.
Majority shareholders’ trading
Aside from the controversy over whether there needs to be an extended period in which insiders are prohibited from trading the shares of their companies, it is safe to say that majority shareholders who are consistently fiddling with their own company shareholdings are likely to have their eye off the ball. In the best companies, the major shareholders focus on running the business, not adjusting their shareholdings.
Derivative financial investments
Companies must disclose their trading in these instruments. Be very scared of any corporation that has heavy derivative investments. Many have imploded in recent months but even in better times, it tells investors that the directors have a casino mentality, which is not conducive to sound business.
Annual General Meetings
AGMs tend to be short in Hong Kong. But investors are perfectly entitled to use these events as a unique opportunity to question their directors. Be very aware of companies that hold AGMs at the kind of speed which precludes questioning. The better companies not only encourage questions but use AGMs as an opportunity to describe the company’s strategy and operations.
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