“the balance sheet deserves more attention than Wall Street has been willing to accord it for many years past” Benjamin Graham, Security Analysis
This statement is just as true today as it was when Ben Graham wrote it in 1934. When an investment is going well, understanding the balance sheet seems unimportant. But when things go wrong, investors often look back at what happened and ask themselves “why wasn’t I paying attention to the balance sheet?”
If the earnings represent the output of a company then the balance sheet represents the resources that are utilized by the company in order to generate that output. To look at a company only in terms of what it’s capable of producing is to understand only half the story. To use an analogy, I know my car is capable of achieving a speed 70 mph for long periods of time – this output has been regularly achieved by my car over the last 5 years. But what enables the car to continuously do this? It’s a combination of the engine, the chassis and the wheels – i.e. the resources of the car. I may have driven for 5 years quite comfortably at 70mph, but if the engine is in poor condition I could break down by the side of the road tomorrow. It pays therefore to take a look under the hood once in a while. I tend to study the balance sheet for one of three reasons – as avaluation tool, as a financial health check and as a warning system.
The Balance Sheet as a Valuation Tool
The book value admittedly has limited use as a valuation tool. For fixed assets, the book value is based on historical cost, depreciated over time to reflect the decline in its useful life. While in some cases this is not a bad approximation of the current value, in other cases the market value can deviate quite drastically from the book value. The sophisticated analyst of course has the option to collect their own data – use industry sources to find market values or replacement values. Analysts who cover the industrial or resource sectors will sometimes compare price to replacement cost as an alternative to looking at book value.
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