Q. What kind of information should I be looking at on a company’s balance sheet?
A. You’re in luck, dear readers. There is simply no way to teach balance sheet analysis in a 350-word column. The official definition of “current liabilities” itself is 200 words long. My hunch is that many of you would rather get a hot poker in the eye, anyway.
Fortunately, there are many resources out there for the motivated investor – the best being Graham and Dodd’s Security Analysis. I’ll cover just a few highlights here.
And rest easy, math-phobes. There is only one equation you need to remember: Assets = liabilities + shareholders’ equity. Or, the stuff on the left must equal the stuff on the right, so the two sides “balance.” Hey, nobody hires accountants for their creativity.
The balance sheets of companies in the finance, utility and railroad industries are a bit specialized. Most retailers and manufacturers, however, use fairly consistent terminology and formatting. At a high level, then, on the left side are assets, or what the company owns; on the upper right side are liabilities, or what the company owes; and on the lower right side is shareholders’ equity, or what has been invested in the company. Liabilities are listed above equity on the balance sheet to remind you that the debtors have a higher claim on assets than stockholders. So don’t get too cocky. Also remember that a balance sheet is a snapshot at a given point in time, not a record of changes.
In his book, Ben Graham summarized a key point in balance sheet analysis: “The liabilities are real, but the value of assets must be questioned.” Except for cash, the value of assets is often up to management’s accounting philosophies. The value of liabilities is not subjective, however, and it’s usually not worth the effort to scrutinize shareholders’ equity. So to analyze balance sheets well, focus on assets.
While the balance sheet can be a strong indicator of the health of a business, it’s also backward-looking. It doesn’t tell much about future income. We’ll get to that next.
From my column in today’s Keys Weekly.
Q. How should I start learning about a company I might invest in?
A. Investors are fortunate that the SEC requires public companies to publish comprehensive financial information about themselves. Unfortunately, much of that information often looks like corporate propaganda. So while I’d suggest the first place you start learning about a company is by reading its annual report, it’s important to clarify the version I’m referring to.
To many investors, a company’s annual report is a color brochure full of pictures and platitudes that really don’t tell you anything at all. My advice? Throw that one out. Go find the company’s actual filings with the SEC instead.
All public company filings are available for free on the SEC’s “EDGAR” website. Go to http://www.sec.gov/edgar.shtml then click on “Company Name.” Enter a company name, and then look for “Form 10-K.”
The 10-K is similar to the glossy annual report, only it goes into much further detail. It comes without the pictures and platitudes. It looks boring and staid because, well, it’s a government document. When it comes to investing, that’s a good thing.
A 10-K should be an investor’s first source of information about a company. It contains a detailed, objective description of almost everything you would want to know about a business, including product lines, divisions, technologies, patents, customer base, and more. You’ll find information about the markets the company operates in, any legal proceedings it’s involved in, and even management’s own analysis of past results and future plans. Companies write them, lawyers review them, and the accountants bless them.
Form 10-Ks also include a company’s financial reports – in greater detail, over a longer time period, and with more complete notes than in the glossy version. You’ll find a balance sheet, which captures a company’s financial position at a point in time; an income statement, which shows the company’s performance over a range of time; and a statement of cash flows, showing company activity and performance in cash terms.
We’ll get to each statement in my next columns. To really know a company, you’ve got to look at all three.
My column in today’s Keys Weekly.
Q. How should I think about risk when investing in stocks?
A. Risk is a highly theoretical, strongly debated topic when it comes to investing. I wrote a partially tongue-in-cheek answer to this question last fall, but I’ll try again without the lame humor.
When it comes to investing in stocks, Wall Street and academia have traditionally described risk using a metric called “beta,” which quantifies the movements of a stock’s price compared to both the market as well as the price of other stocks. The general rule of thumb is that a beta greater than 1.0 means the stock will fluctuate up and down more than the broader stock market, while a beta lower than that threshold means it will fluctuate less – or even in the opposite direction. By this logic, high beta stocks are riskier, and low beta stocks are safer.
Here is the problem with that approach, however. It measures the fluctuation of stock prices, not business value. Rational investors should not be concerned with stock price changes – except when you can take advantage of them. The only thing that really should matter is how the stock price compares to the long-term value of the business.
Relying on beta can fly in the face of common sense. For instance, Google shares had a higher beta at $260 per share at the end of 2008 then at $700 per share at the end of 2007. Now, I ask you…when was the riskier time to buy?
To value investors, beta is useful only when it confirms something you probably already know – that the stock price is volatile because the company’s long-term prospects are, too. Otherwise, I think it’s better to think of risk in common-sense terms. Specifically, what are the odds that you’re going to lose all of your money, or see a permanent decline in your investment?
You should attempt to minimize that kind of risk every way possible – starting with sticking to companies with clear and consistent future prospects. But you’ll miss some great investment opportunities if you confuse volatility in stock prices with real risk.
@PhilipEtienne No, will watch for a bit. Here's to hoping for another overblown scare in a few weeks, though. in reply to PhilipEtienne 5 hrs ago
