4. Find the earnings number in the “Average Estimate” row under the quarter you’re interested in. That’s the earnings estimate.
Once the company reports its earnings, you can then compare the actual earnings with the estimate.
It can be tricky to get an apples-to-apples comparison between the analysts’
EPS estimate and the actual reported EPS from the company. While analysts will usually forecast operating earnings, companies may sometimes include unusual and nonrecurring items that make comparison with the estimate problematic. For that reason, many companies attempt to help investors by offering pro forma earnings. Pro forma earnings don’t follow GAAP. Instead, adjustments are made by the company to make the reported EPS match the estimate.
Pro forma earnings can be helpful when you’re trying to see if a company’s earnings beat, matched or missed earnings estimates. But pro forma earn- ings can also be abused by companies. By not following GAAP, companies have great leeway in adding certain one-time gains and ignoring charges they’d rather you not see. The Securities and Exchange Commission in 2002, for instance, said Trump Hotels & Casino Resorts departed from accounting rules and gave a misleading impression the company beat estimates when it reported quarterly results in October 1999. While the company told inves- tors it was leaving out a one-time $81.4 million charge, it didn’t disclose it also added a one-time gain of $17.2 million to its results. Investors assumed the company beat estimates due to strong performance, the SEC said, when in fact, Trump’s numbers were lifted by the gain.
Measuring A Company’s Staying Power with the Balance Sheet
In This Chapter
▶ Calculating the size of a company’s financial resources using the balance sheet
▶ Discerning the difference between a company that is financed by debt or stock
▶ Realizing the importance of watching a company’s working capital
▶ Gaining awareness of companies’ ability to water down your holding with dilution
For many investors, following how companies are doing each quarter is almost a sport. Some investors may read about companies’ earnings and revenue, just as sports fans follow the track records of their favorite teams.
And certainly, knowing how well a company is doing, or how strong its busi- ness is operating, is an important part of fundamental analysis. But knowing about earnings and revenue is just the tip of the fundamental analysis ice- berg. Fundamental analysts not only know how a company is doing, but what kind of financial shape it’s in.
And that’s why it’s important for you to understand how to dig into a com- pany’s balance sheet. The balance sheet is a financial statement that tells you if a company is financially healthy. A strong balance sheet, or one that’s rich in cash and low on debt, can help a company endure a severe but temporary downturn in its business.
In this chapter, you’ll take a tour of the balance sheet and gain an under- standing of how this financial statement can help improve the results of your fundamental analysis.
Familiarizing Yourself with the Balance Sheet
If you’ve ever calculated your personal net worth, you already have a pretty good understanding of what a company’s balance sheet is. When you tally up your net worth, you generally perform a quick calculation that might look something like this:
Value of things you own – value of things you owe = net worth
Consider this simple personal finance situation: You bought a $200,000 house, put 20% down ($40,000) and borrowed the rest ($160,000). Meanwhile, you have $20,000 in your savings account. You would calculate your net worth like this:
$200,000 (home value) + $20,000 (savings) – $160,000 (loan amount) =
$60,000 net worth
Keep this example in mind as you learn about how a company measures its assets, liabilities, and equity, as explained next.
Separating your assets from your liabilities
Just as biologists classify living creatures by placing them in a genus and species, accountants attempt to put everything companies own and owe into three buckets. Those buckets are:
✓ Assets: Things a company owns. These might include tangible assets, such as physical manufacturing plants or raw materials sitting in a ware- house. Assets, too, might be intangible. Intangible assets are things like patents and trademarks, which have value even though you can’t touch them.
✓ Liabilities: Things a company owes. Usually, liabilities include debt the company is on the hook for.
✓ Shareholders’ equity (or just equity): What’s left of a company’s assets after accounting for its liabilities. Technically, equity represents all the money put into the company by investors and the portion of the profits the company has held onto. When companies hold onto earnings, rather than returning them to shareholders (often in the form a dividend), they are called retained earnings. It’s the equivalent to your own net worth.
The most basic equation of business
Once accountants place a company’s assets and liabilities into the proper buckets, it’s possible to apply some basic math. And the calculation you use to measure your net worth is practically identical to how companies measure their shareholders’ equity. The formula companies use is just rearranged a bit and the terms are different.
Companies don’t necessarily refer to net worth. Net worth is more of a term used in personal finance. Instead, the difference between what companies own and what they owe is called shareholders’ equity.
So, here’s the most basic formula used in business and the fundamental building block behind the balance sheet:
Assets = Liabilities + Equity
As you can see, this formula states a company’s assets must equal the sum of what it owes and what the shareholders own (shareholders’ equity). At all times, a company’s assets must equal the sum of its liabilities and equity. The fact that both sides of this equation must be equal, or balance, is where the balance sheet gets its name. Clever, I know.
Some investors have an easier time understanding the fundamental formula used on the balance sheet by picturing it visually. For you right-brained read- ers out there, below in Table 6-1 is a diagram that’s often scribbled on the blackboard in Accounting 101 classes.
Understanding the Parts of the Balance Sheet
Now that you understand the basic structure of the balance sheet, it’s time to start picking it apart. To do this, first know assets, liabilities, and equity can each be broken down further into smaller, more telling components.
Deconstructing a company’s assets, liabilities and equity can be extremely useful in understanding how a company funds itself and keeps paying the bills by managing its ready-and-available cash, called working capital.
When you dissect a balance sheet, you begin to gain deeper knowledge about all the moving parts that make up a company. The balance sheet tells you what a company owns, what it’s borrowing, and where it gets the money to keep itself in operation.
Table 6-1 Visual Take on the Balance Sheet
Assets Liabilities
+ Equity
Covering your bases with assets
The best place to start exploring a company’s balance sheet is its list of assets. The portion of the balance sheet that records a company’s assets typically has the following parts:
✓ Current assets: A company’s current assets are things it owns that could theoretically be sold for cash within a year. These assets, also called short-term assets, are those the company can tap reasonable quickly to meet immediate cash obligations. Current assets can be further broken down into:
• Cash: This is the easiest asset to understand. Companies have sav- ings accounts, too, and keep cash handy to pay bills.
• Cash equivalents: Companies will sometimes invest cash that’s stockpiled in short-term and high-quality investments that can be quickly sold. These investments give companies liquidity, or access to cash, but allow them to earn a slightly higher return that just holding cash.
When many fundamental analysts refer to a company’s cash, they are usually including cash equivalents in addition to cold-hard cash.
• Marketable securities: Sometimes companies have cash available that they don’t need immediately, but expect they might need within a year. They might invest this cash in high-quality debt that matures in a quarter or two. These investments are relatively safe, but not as readily accessible as actual cash or cash equivalents.
• Accounts receivable: When companies sell a product, they often don’t collect the cash right away. If you buy a book, for instance, you might use your credit card and the merchant isn’t paid imme- diately. These short-term IOUs are called accounts receivable.
• Inventories: Companies must spend money to accumulate the things they plan to sell. Nearly all manufacturing companies, for instance, must buy raw materials to make their products. The value of these assets show up in the inventories line.
• Prepaid expenses. If a company pays a bill ahead of time, it has a credit with the supplier or merchant. That credit is an asset, since
✓ Long-term liabilities:
• Property, plant and equipment. Assets that cannot be turned into cash in a year are called long-term assets. One of the biggest groups of long-term assets include a company’s property, plant and equipment, nicknamed PP&E. These assets include buildings and other machinery and computers a company might own. For an oil company, for instance, PP&E might be oil rigs used to pull crude out of the earth.
• Goodwill. Goodwill is an asset you can’t feel or touch, making it intangible. Goodwill usually appears on a company’s balance sheet after it buys another company. Goodwill is the amount paid for another company, above that company’s actual value according to accounting rules. The extra amount paid is considered an asset on the acquiring company’s balance sheet.
• Other intangibles. Goodwill isn’t the only asset a company might have that can’t be touched or seen. Patents, brands and trade- marks, for instance, have value even though they’re not physical items.
• Total assets. All of the assets are added up to create a grand total of everything the company owns. This is called total assets and will be a number that’s used frequently in analysis, especially with financial ratios discussed in Chapter 8.
Total assets is an important number on the balance sheet. It must, and will, match the total of the company’s liabilities and equity.
Just to give you an idea of what to expect when perusing the asset section of a balance sheet, Figure 6-1 shows you the top section of Hershey Food’s 2007 balance sheet.
Getting in touch with a company’s liabilities
Just like it seems there’s always a bill in your mailbox when you open it, the same goes for companies. During the normal course of business, companies have hungry suppliers and service providers who demand to be paid for their products or services. But bills are just one form of liabilities companies have. The liabilities section of a balance sheet breaks down everything com- panies owe into these parts:
✓ Current liabilities: If a company has bills that are due within a year’s time, they’re considered to be current liabilities. Not paying these bills usually means trouble for a company. Current liabilities come in several
• Accounts payable: Companies don’t typically have to pay right away for things they buy. Suppliers will usually extend trade credit to companies, giving them at least 30 days or even longer to pay for certain supplies, raw materials or services.
• Short-term debt: This is the amount of debt the company must pay back within a year.
• Current portion of long-term debt: Typically companies arrange to borrow money for many years. A portion of that long-term debt, though, is generally due within a year and is called the current por- tion of long-term debt.
• Other current liabilities. Here’s the catch-all bucket for liabilities that don’t quite fit anywhere else.
✓ Long-term liabilities:
• Long-term debt: The costs of starting and maintaining a business can be massive. As a result, some companies turn to lenders to borrow money from, and if they’re lucky, they can line up long-term debt that doesn’t have to be paid for more than a year or longer.
Keeping an eye on a company’s long-term debt load is critical.
While only the current portion is due within a year, the year of debt may come due shortly. If the company is unable to pay the debt or refinance it by borrowing from someone else, the company may default. When a company defaults, the lenders may threaten to take control of the company.
• Other long-term liabilities: This includes liabilities, due in more than a year, that don’t fit in any of the other categories. A company will break down liabilities that are in here in the footnotes to the financial statements. The footnotes, typically available in a compa- ny’s 10-Q or 10-K, provide a more detailed breakdown of liabilities.
• Deferred income taxes: Companies must keep two sets of financial statements. There’s the version you see, which is presented in this book, and a version for tax purposes for the IRS. Sometimes the accounting for taxes can be quite different in the two sets of books.
Deferred income taxes help reconcile the differences. If a company has deferred income taxes, that means it may owe taxes in the future.
The liabilities section of the balance sheet might often look like Figure 6-2, which is from Hershey’s 2007 10-K.
Figure 6-1:
Hershey’s assets on the balance sheet in 2007.
Long-term assets
Hershey’s Assets on 2007 Balance Sheet
Current assets In $ thousands
1,426,574 Total current assets
Property, plant and equipment 1,539,715
4,247,113 Total assets
540,249 Other assets
155,862 Other intangibles
584,713 Goodwill
209,906 Prepaid expenses and other
600,185 Inventories
487,285 Accounts receivable
$129,198 Cash and cash equivalents
Figure 6-2:
Hershey’s liabilities on the balance sheet in 2007.
Long-term liabilities
Hershey’s Liabilities on the Balance Sheet in 2007
Current liabilities In $ thousands
1,618,770 Total current liabilities
Long-term debt 1,279,965
3,623,593 Total liabilities
180,842 Deferred income taxes
544,106 Other long-term liabilities
539,359 Other current liabilities
6,104 Current portion of long-term debt
850,288 Short-term debt
$223,019 Accounts payable
Taking stock in a company’s equity
Shareholders’ equity represents the total claim investors have on a com- pany’s assets, free-and-clear of debt. That includes money investors injected into a company, in addition to profits that the company has held back, or retained. The equity section of many companies’ balance sheets include the following sections:
✓ Preferred stock: Companies may issue ownership stakes that are kind of a blend between debt and equity. Like debt, preferred stock pays a cash payment that’s arranged ahead of time. However, as with common stock dividends, companies may suspend these preferred stock payments at any time.
✓ Common stock: When you’re looking to buy a stake of a company, typi- cally these are the shares you’re buying. When you look up a stock quote, most of the time you’re getting the price of a share of a compa- ny’s common stock.
✓ Retained earnings: It’s up to a company whether or not to return its profits to shareholders in the form of dividends. If the company keeps earnings, it records the sum here.
✓ Treasury stock: Sometimes not all of a company’s shares are available to bought or sold. A company might buy back its stock when it thinks it’s cheap, and put it aside. A company might also authorize to issue stock, but not actually issue it. Either way, the pool of unused shares are called treasury stock.
✓ Total shareholders equity: The shareholders equity line of the balance sheet measures the value of shareholders’ stake in the company.
A summary of the equity section of Hershey’s balance sheet appears below in Table 6-2.
Table 6-2 Hershey’s Equity on the Balance Sheet
$ thousands
Preferred stock N/A
Common stock $299,095
Retained earnings $3,927,306
Treasury stock –$4,001,562
Total shareholders’ equity $592,922 Total liabilities and stockholders’ equity $4,247,113
Analyzing the Balance Sheet
Now that you understand the pieces and parts that make up the balance sheet, it’s time to start applying fundamental analysis. Just as you dug more deeply into the income statement in Chapter 5, in this section you’ll develop tools to glean insight from the balance sheet.
Sizing up the balance sheet with common sizing
If you noticed while looking at Hershey’s balance sheet above, just looking at the numbers in isolation isn’t particularly useful. It’s helpful to put the assets, liabilities, and equity into perspective by comparing them with something.
That’s why common sizing, a fundamental analysis tool applied with the income statement in Chapter 5, can be equally helpful when analyzing the balance sheet.
When common sizing a balance sheet, you are attempting to show how sig- nificant a company’s different assets, liabilities and forms of equity are to the entire firm. You only need three formulas to common size the entire balance sheet:
✓ Assets: Divide each type of asset by the company’s total assets.
✓ Liabilities: Divide each type of liability by the company’s total liabilities and stockholder’s equity.
✓ Equity: Divide each category of equity by the company’s total liabilities and stockholders’ equity.
Multiply the results of the three items above by 100 to convert the figures into a percentage.
Imagine if you wanted to see how much Hershey relies on borrowed money, versus money raised from stock investors, to fund itself. That’s a perfect reason to common size the liabilities portion of Hershey’s balance sheet.
To do this, you start with Hershey’s accounts payable ($223,019) and divide it by total liabilities and stockholders’ equity ($4,247,113). The result is 5.3%, and I’ll explain what that means in a bit. First, you might want to finish common sizing the whole statement. Table 6-3 shows you the results of common sizing the key parts of the liabilities and equity portion of Hershey’s balance sheet.
Table 6-3 Common-Size Analysis of Hershey
% of liabilities and shareholders’ equity
Accounts payable 5.3%
Short-term debt 20%
Current portion of long-term debt 0.1%
Total current liabilities 38.1%
Long-term debt 30.1%
Total shareholders’ equity 14%
Common sizing a company’s liabilities gives you an instant view of where Hershey gets the money to keep itself going, or its capital structure.
Understanding a company’s capital structure is key to understanding how well it’s positioned to withstand an economic downturn or how profitable it will be during strong economic growth.
Just by doing a few multiplication problems, you get a very unique funda- mental look into Hershey. You can see Hershey receives its financing from a balanced number of sources, but leans toward relying more on debt. Hershey gets 20% of its financing from short-term loans, more than 30% from long- term loans and 14% from equity.
When companies rely on borrowed money to pay for their operations, it’s called leverage. Leverage can greatly enhance a company’s returns for stock holders as long as the company can comfortably keep up with its interest payments. Interest on debt is largely fixed, much like a monthly payment on a 30-year fixed mortgage is static. Interest also has a tax benefit of being deduct- ible. The question, though, is whether or not a company has borrowed too much. You can find out if a company is overleveraged by analyzing working capital, later in this chapter, and financial ratios in Chapter 8.
Looking for trends using index-number analysis
While balance sheets take a snapshot of a company’s assets, liabilities and equity at a set time of the year, the parts inside are constantly changing.
When interest rates are low, for instance, a company may decide to leverage itself by borrowing more. Similarly, when stock prices are lofty, a company may choose to raise equity by selling stock.