Benjamin Graham's The Intelligent Investor is the quintessential book for serious investors. If I had a chance to go back and rename the book, though, I think a more appropriate name would be An Ode to Balance Sheets. While most of us spend our time scouring through the income statement, we have a tendency to overlook the gems that can be found in the balance sheet, which could help you find immense value in the stock market. To get a better understanding of the balance sheet, let's take a look at oil services company Weatherford International's (NYSE:WFT) assets and liabilities and see how it stacks up against its peers.
What is all this gobbledygook anyways?
Scouring through a balance sheet isn't exactly one of those things that makes for a fun, leisurely Sunday afternoon. Sometimes there are components of a company's balance sheet that send you so deep down the rabbit hole you end up asking yourself, "What was I originally looking for?" 45 minutes later. That being said, it is an important aspect of your investment analysis because the balance sheet can help you determine the financial health of the company as well as get a rough idea of the company's market value.
So, as a simple guide, lets focus on three key themes when looking at the balance sheet of Weatherford International and any other company: financial health, efficiency, and value.
Two quick and painless ways of giving a company a financial physical are looking at the debt to capital ratio and the interest expense to EBITDA ratio. Debt to capital is the percent of capital that is debt, and this is a quick snapshot of its financial standing. Companies with higher debt to capital ratios might have to make big interest payments, leaving equity investors with nothing but table scraps. However, lots of cheap debt can be better than a little expensive debt, so we can keep things in context with the interest expense to EBITDA ratio because it shows the company's ability to cover its obligations. If a company has an interest expense to EBITDA ratio of less than 1, then it pays more in interest than what it can generate.
Here's a quick look at Weatherford's debt profile compared to its closest peers:
|Company||Debt to Capital||Interest Expense to EBITDA|
|Baker Hughes Inc||19.32%||17.37x|
|National Oilwell Varco||11.65%||42.54x|
I believe that the highly technical term for Weatherford's financial health is "up to its ears in debt." This is slightly concerning for a company in the oil services industry because it is a very cyclical business that is subject to ups and downs. So if the industry were to head south anytime soon Weatherford would be in much more trouble than its peers.
It's not the size that matters, it's how you use it!
That train of thought can apply to assets, too. A company might have billions of dollars of property, plant, and equipment, but it doesn't matter if all they do is gather cobwebs. A way that we can evaluate this is by looking at three metrics: asset turnover, the working capital ratio, and the return on assets. Asset turnover is the total annual revenue divided by total assets; it's a rough way to gauge how much money those assets bring in the door. The working capital ratio is the company's current assets -- things like cash and inventory -- divided by its current liabilities -- accounts payable, debt that needs to be paid that year, things like that. It measures how well the company deploys its current assets: Less than 1 means it could run into short-term issues with creditors, and high numbers suggest the company isn't efficiently deploying its current assets. Finally, return on assets is net income divided by total assets, and it shows the ability for that company to drive profitability from its assets.
Here's a glimpse at Weatherford and how it stacks up:
|Company||Asset Turnover||Working Capital Ratio||Return on Assets|
|Baker Hughes Inc||0.82x||2.51x||5.2%|
|National Oilwell Varco||0.71x||2.30x||6.9%|
One thing that stands out immediately with all of these oil services companies is that they have pretty low asset turnover. This isn't too surprising, though, because not all of a company's assets will be working at all times. This is why for many oil services companies utilization rate is important
If we focus in on Weatherford, we have a rather peculiar case. It has a pretty low asset turnover as well as a low return on assets, but its working capital ratio suggests that the company is pretty effective at deploying capital. What this might suggest is that the things that are working are working effectively, but there is a lot of dead weight on the books dragging down profitability.
The only thing that should be held in as high esteem with the quality of a company's assets is how much you pay for them. Overpaying for even a great asset will likely result in poor returns -- but even worse if you overpay for low quality assets.
To describe this value, Benjamin coined the term "margin of safety," which is the concept that the value of a company's assets are valued so cheaply, that you are pretty much guaranteed a return. A quick and dirty way to get an idea of this is to look at two metrics: the intangible asset ratio and the price to tangible book value ratio. The intangible asset ratio lets you know how much of a company's assets are tied up in things you can't see or touch. For some companies, intangibles can be very valuable -- what is Coca-Cola without its brand or a tech company without patents? -- but for others they may artificially inflate its value. Then we have price to tangible book value, which is market capitalization divided by total tangible assets. This basically shows what Wall Street thinks a company's physical assets are worth at any given moment.
So, is there a margin of safety buying Weatherford?
|Company||Intangible Asset Ratio||Price to Tangible Book Value|
|Baker Hughes Inc||24.1%||2.5x|
|National Oilwell Varco||39.7%||4.4x|
Remember, not all intangible assets are created equal. While brand might be a hard sell for these companies, many of them have several valuable intangible assets such as technology patents, seismic data from multiple clients, and some have long-term investments. For example, while Weatherford has a modest intangible asset ratio compared to its peers, 86% of it is in goodwill alone, whereas less than two thirds of National Oilwell Varco's intangible assets are from goodwill.
Based on Weatherfords price to tangible book, it isn't exactly selling at a discount to its peers, and 4-6 times tangible book wouldn't even come close to what Graham would look for as a value investment.
What a Fool believes
You might not think it looking at these figures, but Weatherford International is on a tear this year with shares up 37% year to date, the best performance of all the companies mentioned.
A lot of it has to do with the company's plans to sell off several less profitable segments to both increase overall returns as well as move toward a debt to capital ratio around 25% by 2016. Based on some of Weatherford's asset efficiency metrics it looks like there is a lot of fat to trim. While it may be tempting to invest in this turnaround, it looks as though its assets -- including the ones it wants to sell -- are still valued by the market on par with its peers. Personally, I'm willing to wait and see what the company looks like post turnaround before making any investment decisions.
The Motley Fool recommends Halliburton and National Oilwell Varco. The Motley Fool owns shares of National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.