When anyone asks, I always say the balance sheet is my favorite financial statement (and yes, it comes up all the time -- I go to some pretty cool parties).
Unlike the income and cash flow statements, the balance sheet provides a snapshot in time, showing what a company owns and owes right now. That means we can use it not only to assess a company's value, but also to diagnose a company's financial health.
At Million Dollar Portfolio, we most often use balance sheets for the latter purpose. By making sure that a company's debt load isn't too high and that its cash flow stream can easily service the interest on that debt, we can be confident that the company can survive tough times.
And although we Fools tend to focus on profit and cash flow when it comes to assessing a company's value, certain industries -- insurance, asset management, and businesses with significant assets such as land or timber -- lend themselves to a balance-sheet-based valuation model.
When it pays to be big on book value
Estimate the current value of everything a company owns (including current assets -- cash, investments, and inventory -- and fixed assets such as land and manufacturing facilities) and then subtract everything it owes, and you have the company's adjusted book value. Find a company selling for less than that value, and there's a chance that you've uncovered an exciting investment opportunity.
Here at MDP, we own two companies that we look at from a balance sheet perspective: Markel (NYSE: MKL ) and Berkshire Hathaway (NYSE: BRK-B ) . Companies like these are often called "jockey plays" because their business models depend on management's ability to skillfully invest one of the most important assets around: cash. And by comparing stock price with book value, we can see what investors are willing to pay for management's expertise and determine whether it's a worthwhile opportunity.
Energy companies such as Chesapeake Energy (NYSE: CHK ) can also be analyzed from a balance sheet perspective because we can think about them in terms of the current (or future) value of what they own, namely oil and natural gas reserves.
An extreme example of a book-value play is the "net-net," developed by the fathers of value investing, Benjamin Graham and David Dodd. By finding stocks that are trading for less than current assets only minus all liabilities, shareholders essentially get the fixed assets of the business for free.
In today's market, net-nets are very hard to find, but during bear markets and market corrections, they occasionally pop up. A quick look for net-nets uncovered consumer electronics company Audiovox (Nasdaq: VOXX ) and footwear company Heelys (Nasdaq: HLYS ) .
But we need to be careful; a stock trading at such a potentially cheap valuation is often warning us that something is drastically wrong with the business.
Accounting for book value quirks
When undertaking a balance sheet analysis, investors need to be aware that the asset values listed don't always reflect reality.
The best example of this is real estate. Land is recorded on the balance sheet at cost -- so if the Dutch West India Co. still owned the island of Manhattan, its balance sheet would still show a cost basis of merely $24.
When we're doing analysis, we need to properly adjust the company's asset base so it reflects its current value. Restaurant behemoth McDonald's (NYSE: MCD ) is a good example of a company with a ton of real estate that could potentially be worth more than is reflected on the balance sheet.
We also need to account for off-balance-sheet items, such as an over- or underfunded pension, that might not show up in the financial statements. A good example of a company with an underfunded pension is soup maker Campbell (NYSE: CPB ) .
Finally, it's important to note that the proper values for balance sheet assets shouldn't be thought of separately from the income and cash flow statements. In fact, the true value of an asset is the present value of the cash flow that can be produced by that asset.
So if a manufacturing facility produces something that won't generate future cash flow -- say, it's the last Walkman factory -- we need to account for the fact that, unless it can be converted to another use, the facility is really worth much less than what's on the balance sheet. This concept can be helpful if you're going to take the time to comb through a company's assets and try to determine their appropriate value.
But book value isn't the only thing we look at in Million Dollar Portfolio. If you'd like more stock ideas, enter your email address in the box below to get "Motley Fool Top Picks & Perspectives 2011," a new free report with stock recommendations and portfolio guidance for the year ahead. We'll also tell you more about Million Dollar Portfolio, our real-money portfolio service that buys the best of our investing ideas, opening for the last time this year. To get started, just enter your email addressin the box below.