As an investor, you probably already know that a company's balance sheet can tell you what it owns and what it owes. But you may not know that many of the numbers on the balance sheet represent accounting logic, and not necessarily the true value of the assets being reported. If you're relying on that balance sheet to make investing decisions, be forewarned: Even legal numbers can bear no resemblance to what the items being reported are really worth.
For instance, after eBay (NASDAQ:EBAY) purchased Skype, a huge portion of the purchase price was reported on eBay's balance sheet as a financial asset called "goodwill". Yet when eBay announced a massive goodwill write-off associated with that purchase, a large chunk of that hypothetical asset simply disappeared. Likewise, Cisco (NASDAQ:CSCO) wrote off about $2.5 billion in inventory back in 2001, largely because it no longer thought it could sell those products.
Ouch!
With the stroke of a pen, billions of dollars of what an investor may have considered a company's net worth can simply be eliminated. Such is the nature of a balance sheet. Assets get reported there -- often at some price linked to their historical cost -- until they're scrapped, sold, amortized away, or determined to be worthless and written off entirely.
What does that mean to you as an investor? Simply this: Searching for stocks trading at bargain-basement prices requires far more than a simple screen for a low price-to-book ratio. If the book values of the company's assets don't accurately reflect what they're really worth today, you might wind up with a whole lot less for your investing dollar than you were expecting.
Housing's crumbling foundation
Consider what's happening right now in the housing market, and to the lending institutions that make a large chunk of their money loaning money to homeowners. The burst bubble stranded the homebuilders with a huge chunk of unsold inventory on their balance sheets. If that inventory doesn't move, it will need to be either discarded at a loss or written off entirely.
The same burst bubble means that banks that loaned out cash near the peak now have major problems. Many of the loans sitting as assets on their books are no longer covered by the value of the homes securing those loans. While the vast majority of borrowers will likely keep making their payments, the heavily leveraged nature of the banking industry will magnify the losses from those who default. Foreclosures themselves are expensive, and in a deflating housing market, the banks will likely get only a fraction of what they're owed from any resale of foreclosed homes.
Deceptively cheap stocks
As a result of these very real problems, homebuilders and banks will have difficulties collecting cash for their assets; many carry market prices dramatically below their reported book values. For instance:
|
Company |
Price-to-Book Ratio |
|---|---|
|
Wachovia (NYSE:WB) |
0.46 |
|
Washington Mutual (NYSE:WM) |
0.27 |
|
Beazer Homes (NYSE:BZH) |
0.30 |
|
Standard Pacific (NYSE:SPF) |
0.21 |
|
National City (NYSE:NCC) |
0.20 |
Source: CapitalIQ as of Aug. 26.
While many of the companies on this list will likely survive this crisis, their price-to-book ratios are extremely low for very good reasons. The market is expecting further asset writedowns that will knock even more assets off their balance sheets. As a result, their book values should be viewed with a jaundiced eye; they don't provide the backstop they would if the banks' assets could all be readily converted into cash.
Find true values
A company's book value is only as strong as the assets that appear on its balance sheet. If they can't be readily converted into cash, they may as well not exist at all. Unless you're expecting a liquidation sale, a firm's earnings potential is far more important than what it owns.
That's why at Motley Fool Inside Value, our primary focus is on operational metrics and cash flow production, rather than pure asset plays. Over time, the ability to generate money for a company's owners counts most.
If you're ready to graduate from simple ratio-based investing, and focus on what the companies behind your stocks can truly deliver to you, join us at Inside Value. If you'd rather kick our tires first, that's fine, too. You can take the next 30 days to look around free while you start to learn how to seek out values beyond the balance sheet. Get started now.
