Intrinsic Value – Balance Sheet Fundamentals<\/span><\/strong><\/span><\/h1>\n

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The key to understanding intrinsic value is grasping the fundamentals of the balance sheet. The balance sheet reflects the lifetime to date accrued net worth of that business entity. For the value investor, understanding how a balance sheet is laid out, works and how it reports net worth takes the investor to the next level of confidence with their buy\/sell model for any potential investment. Simply stated, understanding the balance sheet places the value investor ahead of other types of investors. Knowledge about the balance sheet for your investment can provide all the necessary confidence you need to make good decisions when setting buy and sell points for that company’s securities.\u00a0<\/span><\/p>\n

In essence, the balance sheet is a scale. Accounting ensures the scale always stays in balance. It is laid out with two sides; on one side of the scale are all the existing assets of the company. The other side informs the reader how those assets are funded. More mature or well managed companies fund assets with the lifetime earnings to date that are retained. Some companies borrow the money to pay for the assets. As an example, most people don’t realize this, but McDonalds funds the entire asset side of the scale with borrowed money and then some. Yet, McDonalds is one of the top 30 companies in the world. Thus, how can McDonalds have any intrinsic value when they actually owe more money to creditors than they have in assets?<\/span><\/p>\n

This is why value investors must have a good fundamental understanding of how the balance sheet works.\u00a0<\/span><\/p>\n

In addition, the balance sheet acts as a report. It informs the reader what kind of assets the company owns and it details how those assets were funded. Understanding this fundamental reporting format allows the value investor the ability to quickly get to the core reason the company has value. In many cases, understanding this reporting format allows the reader to easily determine a viable range of expected outcomes for intrinsic value.\u00a0<\/span><\/p>\n

Understanding the balance sheet fundamentals allows investors to not only determine the core value of a company but its also assists the investor with determining which particular intrinsic value formula is the most reliable to use. You must understand these fundamental balance sheet relationships to assist with determining the best intrinsic value formula. In most cases, the balance sheet will provide the intrinsic value (subsequent articles) for the company. But without this knowledge, an investor can’t possible have a high level of confidence with intrinsic value formulas. It all starts with understanding the fundamentals of the balance sheet.<\/span><\/p>\n

Fundamental understanding of the balance sheet starts out with keying in on the concept of balance. Once this core principle of balance is comprehended, an investor then must understand that THERE IS NO UNIVERSALLY ACCEPTED PRESENTATION FORMAT<\/strong><\/span>. There is a simple balance sheet presentation format that is ingrained into formal education of accountants; but, at the public securities level, industries have set how a balance sheet is presented. What is important here is that although the industry’s balance sheet format is different, it is still easy to comprehend this alternative presentation format and how it ties back to the basic presentation format.<\/span><\/p>\n

Finally, after grasping how a balance sheet is laid out and works; a value investor begins to appreciate each industry’s presentation format. Now it is time to key in on the real reason all this is so important; matching the most important asset on the balance sheet to how this entity makes its money. What is the one or two most important assets and how they are presented aids the investor with determining value. How does a value investor discover this asset and how does one determines its value?<\/span><\/p>\n

Each section below goes into this set of core fundamentals of a balance sheet. When done, the reader should be able to break any company’s balance sheet out into the core groupings and quickly ascertain the proper format for the company one wishes to invest. From there, a value investor will quickly key in the most important asset that makes this company go; what is the one single most important asset that provides all that wealth? With this understanding, a value investor can more easily derive intrinsic value and have extreme confidence with the intrinsic value outcome.\u00a0<\/span><\/p>\n

Intrinsic Value – The Balance Sheet<\/strong><\/span><\/h2>\n

The balance sheet is one of the five key financial reports. It is a required presentation with the company’s annual 10K report filed with the Security and Exchange Commission. Most publicly traded companies also include the report with their quarterly releases. The balance sheet identifies existing assets along with the sources of funds to finance the company. Sources of funds include liabilities, loans and money fronted by the shareholders and other equity stakeholders. Generally Accepted Accounting Principles (GAAP) and the accounting profession’s dual entry accounting system forces the balance sheet to exist in a state of equilibrium, thus the expression, ‘the balance sheet’.<\/span><\/p>\n

As an investor, it is important to understand the primary purpose of the balance sheet; the balance sheet reflects the lifetime to date financial position of the company. The income statement only reflects the accounting year, whereas the balance sheet is just a snapshot of a single moment in time which is identified by the date of the report. The balance sheet states the book value of all assets and the book value of all debt (current and long-term) along with the resulting aggregated position of all stakeholders (Preferred Stock, Minority\/Joint Owners, Treasury Stock and Shareholders). It starts out with a very simple equation:<\/span><\/p>\n

ASSETS = SOURCES OF FUNDS<\/span><\/strong> (the core balance sheet)<\/span><\/p>\n

This is then broaden out to reflect the two major sources of funds which have different risk levels:<\/span><\/p>\n

ASSETS = LIABILITIES<\/span><\/strong> (preferred rights, less risk)
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 plus
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0EQUITY<\/span><\/strong><\/span> (subordinate position to liabilities, greater risk)<\/span><\/p>\n

In effect, the balance sheet is a three part formula. Part One reflects assets such as cash in the bank, receivables, fixed and other assets. Some of these assets are funded by short-term liabilities while others are funded with long-term loans (notes). Subsequently, liabilities are Part Two of the formula. The final part is of course equity. Equity in a simple state refers to what the shareholders have invested in the company. This investment is the initial purchase price paid to start the company plus the lifetime to date earnings referred to as ‘retained earnings’. Recall, each year as the company earns a profit, any profit not used to pay dividends or buy back stock (treasury stock) is then accumulated in an account called retained earnings. The end result is:<\/span><\/p>\n

ASSETS = LIABILITIES + EQUITY<\/span><\/strong><\/span><\/p>\n

An easy observation is that this formula can be rearranged to state the value from the perspective of just the shareholders:<\/span><\/p>\n

ASSETS minus LIABILITIES = EQUITY<\/span><\/strong><\/span><\/p>\n

This presentation format is not referred as the balance sheet, but as ‘Net Assets’. It is important for the reader to understand that there is a naming difference involved as often different wording is used to identify the various presentation formats of the balance sheet. The balance sheet refers to the core formula of assets equals liabilities plus equity. When referring to assets minus liabilities equals equity, accountants and finance folks refer to this as ‘Net Assets’. Notice how net assets equals assets minus liabilities. Thus:<\/span><\/p>\n

NET ASSETS (assets minus liabilities) = EQUITY<\/span><\/strong><\/span><\/p>\n

This is key, value investors more often use the term ‘Net Assets’ when talking about value than the alternative term of ‘Balance Sheet’. Mathematically though, the two terms are referring to same financial equation; specifically, what is the value of the equity position of the company. An illustration will assist the reader in understanding this relationship:<\/span><\/p>\n

This is the balance sheet for a real estate investment trust (REIT), American Homes 4 Rent, Inc. This company owns 56,400 homes throughout the United States. This is their balance sheet at 12\/31\/2021. <\/span><\/p>\n