Last week, we covered the current ratio, quick ratio, and working capital, and their relevance to the balance sheet. We'll finish the series tonight with a few more tools designed to aid in the evaluation of public companies as an investment.
Enterprise Value is the market capitalization of a company, plus debt, minus cash and investments. Debt is added because a purchaser of the company would have to assume that debt in the transaction, and cash and equivalents are subtracted simply because if you were to buy a company, the cash and investments coming back to you would in effect reduce the price tag by that amount.
Enterprise value is a more realistic snapshot of a company's current net value than market capitalization alone. Because of this, it's a good idea to substitute enterprise value for market capitalization in the price-to-sales ratio (market cap divided by trailing 12-month revenues) when comparing how a company is valued relative to its peers.
Price-to-Book Ratio is calculated by dividing the market capitalization of a company by its book value. Book Value, (also known as shareholder's equity) which is calculated by subtracting total liabilities from total assets, is a rough estimation of the liquidation value of a company.
Price-to-book is somewhat limited in today's world due to the significance it places on capital assets. Company's such as Intel (Nasdaq: INTC), which is high on margins and low on capital assets, would seem relatively overvalued based on price-to-book due to its low book value. The ratio may carry some usefulness in evaluating companies in the banking, brokerage, and credit card industries, where takeovers are often based on book value multiples (usually between 1.7 and 2.0 times book), as well as capital-intensive businesses such industrials.
Another problem with price-to-book is that stock buybacks lower book value. This reflects inflated valuation using this metric, when in fact, value has been enhanced by the repurchase.
Asset Turns are sales divided by total assets. Comparing present asset turns with previous quarters or years will tell you if assets are ballooning in comparison to sales. Assets growth outpacing sales will usually be due to higher inventories and/or accounts receivables.
Inventory Turns are cost of goods sold divided by average inventory for the year. Naturally, you'll want inventory turnover to be high. The more inventory a company has piling up, the less money available to grow and run the business.
Accounts Receivables Turnover is the sales for a period divided by the average accounts receivable for that period. This is a measure of how many times a company clears its books of outstanding credit issued. When comparing two similar companies, an immediate edge would be given to the one that is turning over its accounts receivable in a more timely fashion.
Days Sales Outstanding (DSO) is a measure of how many days worth of sales the current accounts receivable represents. To calculate DSO, take the current accounts receivable divided by sales for a period over days in that period. A good measure of credit management, DSO tells us how many days worth of sales are not yet collected. Obviously, the lower DSO, the better for a company. Money not frozen in accounts receivable limbo is money that can be used by and for the business.
This concludes our walk through the balance sheet. I hope this review will be useful to you in evaluating and comparing companies as potential investments. In a few weeks, we'll return to the Back to Basics series with a look at the income statement.
Drip on, Fools!
