This past week, I got a very nice e-mail from a reader of my book who lives in Hong Kong. I could tell he was knowledgeable about the balance sheet. He wondered why the balance sheet does not play a more important role in investing and why so much emphasis is placed on future expectations, growth and earnings. If you’ve read my book and followed my blog posts, you know that this reader is in the same camp of thought as I am.
The aim with stock investments is, of course, to buy at low prices and sell at high(er) prices. We have to get the first part right (buying low) before the second part (selling high) becomes possible. My position is that without the balance sheet, it’s not possible to define a low price. Earnings and growth expectations must be considered when buying, but should not trump the balance sheet’s primary role in finding a low price.
The kind reader posed an excellent question about how to best consider earnings at the time of buying a stock. My practice described in the CSW book is to add the past 12 months earnings per share (eps) figure to my initial floor price in order to derive the adjusted floor price, when there are no analyst projections for the “next” 12 months eps. Oftentimes, there are no analysts covering small company stocks so with those stocks we are often without a forecast of the next year’s eps.
Recall that the initial floor price is found by assessing the balance sheet only. So, by adding 12 months eps, consideration is being given the earnings at the time of assessing a low price. Note that if you have not read my book, some of this terminology (i.e. initial floor price) will probably seem strange.
The reader wondered if, when having to use past earnings to adjust the initial floor price, it would be better to use a multi-year average annual eps number (extracted from past years) rather than using the past 12 months eps, when adjusting the initial floor price. While I gave a more exhaustive answer during our electronic conversation, I’ll give a simplified version here.
Rarely would the eps number be significant relative to the size of the initial floor price number. So, the precision of a past eps number selected is less critical to the final floor price (adjusted floor price). That said, we still don’t want to ignore earnings altogether but rather subordinate the role earnings play to the role of the balance sheet when defining a low price. Using the past 12 months of eps is the most recent number available in the absence of a forecast of the next (forward-looking) 12 months eps. A more recent number is likely more relevant than older eps numbers.
However, an annual eps number extracted as an average of multiple past years might well be more appropriate if the past 12 months eps are anomalous (highly unusual) due to inclusion of non-recurring (one-time) earnings, like a gain on the disposition of a segment of company operations, for instance. That is, an average number from several years could mitigate somewhat for any unusual events (unlikely to be repeated in the future) included in the past 12 months of earnings.
We don’t actually need to go back several years to mitigate for an anomalous effect in the past 12 months eps number, though. Rather, we can go to the Securities and Exchange filings (see my prior blog posts on corporate financial filings) and determine if any non-recurring amount is included in the past 12 months eps number and simply exclude this one-time part from the eps number we blend with the initial floor price.
I appreciate the astute reader from Hong Kong sharing his thoughts with me and posing his excellent question.
Excellent question and great answer!! Enjoyed your response.
Dear Dr Allen,
I recently read your book and found it very insightful. In putting it to practise I came across some mining companies whose market capitalizations suffer from currently depressed mining goods prices, eg iron ore. Stock price is sometimes significantly below initial floor price (calculated as outlined in your book). However, most tangible assets on the balance sheet are mines, and at current iron ore market prices I see a risk of asset value of mines being significantly overstated on the books. Do you have a perspective on this? I would highly appreciate it. Many thanks.
Hey Patrick,
Thanks for reading my book! You make an astute observation on mining companies. It’s interesting; a class I taught last spring locally formed a club following the class where we informally gather to discuss stocks. During a recent discussion, we talked about just the issue you raise. A mining stock was discussed one evening that trades well below the adjusted floor price and one participant wondered if it was not similar to the dry bulk shipping stock situation I described in my book. That is, a lot of the balance sheet equity was in the form of property, plant and equipment (illiquid fixed) assets where demand for the company’s product/service was currently depressed. It is a very legitimate point to consider because the fixed assets might be worth considerably less (or considerably more if metals are doing well) than the 90 percent credit I give them in determining the initial floor price. Mining stocks face a risk different than many companies in that management can’t do much about creating demand via effective marketing because the product (metals) is a commodity that has its price determined aside from management efforts to promote sales. So, mining companies are basically a “bet” on where commodity prices will go next. If metal prices go on a tear, a fundamentally cheap stock in this sector is liable to do extremely well. However, if prices remain depressed, the large resource-based portion of assets probably becomes an albatross to the company’s ability to continue operations. Your comment highlights why “everything” can’t be brought down to a number; mining companies are commodity companies; everything hinges on the underlying commodity price and the company has little control over that other than hedging contracts, which could also work for or against them. Many people simply avoid mining companies because the outlook for future performance is virtually impossible to size up. We want to ideally buy cheap (quality) stocks with a history of profitability and the better the outlook, well, the better. Thanks for the comment and I hope this helps.
Paul
Thanks for your book. i am currently having a challenge buying the book because Amazon does not ship directly to Nigeria.
But here is my question. what is your take on companies with negative equity? will you invest in a company that met your other requirements but carry negative equity? It’s like many companies are deliberately carrying negative equity these days
Hi friend,
You are correct in saying that there are companies with negative equity that meet all the criteria except the P/B. I personally don’t want to invest in companies with negative equity. Liabilities exceeding assets is the definition of insolvency. I agree with you about the company intentions too. Many large companies choose to take on negative equity (usually having substantial debt on the balance sheet) to keep pushing the leverage envelope to push stock price higher and higher. Leverage can expand operations and it can accomplish stock buybacks and these things can produce a higher eps. But the music could stop suddenly too with a major macro travesty. So long as interest on the debt is paid timely, lenders tend to be willing to roll over the principal to where the levered companies don’t ever really settle the debt. To me, I’m a simpleton meaning I’m risk averse and negative equity means a company with more obligations that it has in resources. I may use this as a theme for a future blog post. Thanks for the good question and comment.
Paul