## Chapter 21 – Valuation concept (P/B ratio)

Price-to-Book ratio (P/B): P/E shows the valuation of a company w.r.t. the earnings. P/B on the other hand shows the valuation of a company w.r.t. the book value of Shareholders’ equity. As we discussed, Shareholders’ equity is the difference between Total assets and Total liabilities, i.e. whatever assets are left after fulfilling the obligations of the company. The ratio is calculated as below:

P/B = Market price per share/ Shareholders’ equity per share

While calculating the book value (shareholders’ equity), we should add a small adjustment. We should deduct the value of Goodwill and Intangibles from the Shareholders’ equity as these assets can not be sold at the time of company’s liquidation.

Let’s work this out through an example:

A company XYZ has 1,000 shares. And the latest balance sheet is as below (all numbers in USD):

As per above, we should not use \$7,050 as the Shareholders’ equity since we can see Goodwill and Intangibles on the asset side. We will use the following number instead:

Tangible Shareholders’ equity = 12,050 (Total assets) – 5,000 (Total liabilities) – 1,500 (Goodwill) – 1,000 (Intangibles)

= 4,550

Now divide this by the number of shares to get the Book value per share = 4,550/1,000 = \$4.55 per share

Assume that the share price is \$5.00 today. So let’s calculate the P/B = \$5/\$4.55 = 1.1. This means that the market is pricing the tangible assets at a value greater than book value of equity. Reasons for this could be:

• Intrinsic value of Goodwill and Intangibles: The market realises the capability of assets to earn more than the book value of stock. For example, the company records Goodwill based on the money it paid over and above the Acquiree company’s shareholders’ equity. But it also buys the expertise, infrastructure, customer base, distribution network etc. which can probably produce more income in future than the balance sheet can represent. The reason for this disparity is that the balance sheet is created as of a specific date and does not estimate the future value of assets.
• Hidden asset: The market realises that there is a hidden/undervalued asset on the balance sheet. For example, the company bought a property in New York in 1950 and has been showing it at the original cost of purchase. An enterprising investor made other investors aware of this fact and hence the market started pricing the book value upward accordingly.
• Just a bull market phenomenon: It’s a bull market and there is no regard for fundamentals at the moment. Needless to say, we will keep ourselves away from such scenarios.

Please note that P/B is only one of the other metrics that we have discussed until now. A good way to start searching for value would be to look at companies with P/B <1. It might eliminate some companies with high values of Goodwill and Intangibles (eg. Pharmaceuticals & IT). But if you are fairly confident of analysing the future prospects of Intangibles based on the underlying business, it might result in some good investment opportunities.

Chapter 20 – Valuation concept (P/E ratio)

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## Chapter 20 – Valuation concept (P/E ratio)

Phew! Time to congratulate yourself for your effort on reading till now. Just a few more concepts and we are good to start practicing the art of investing.

Price-Earnings Ratio (P/E): This is one of the most commonly used numbers to describe the value placed by market on the company currently. It is calculated as below:

P/E = Price per share (Market Price)/Earnings per share (EPS)

The only difference is that the EPS used here does not adjust for extraordinary items as discussed in Chapter 17. We should adjust for those items so as to get a multiple corresponding to earning power of the underlying business.

What does P/E represent? The ratio is generally used as a multiple applied to the earnings which simplistically represents the number of years in which you earn equivalent of your capital, i.e. an investment of \$100 grows by \$100 to a total of \$200.

Let’s look at an example. Assume you invest \$100 to purchase 1 stocks of company XYZ with a P/E ratio of 12.5. This means that the company is earning \$8 per share (\$100 price per share/ 12.5 P/E Ratio = \$8 EPS). Assume that the company continues to earn \$8 per share every year and pays out as all of this earning as dividend to the shareholders every year. In this case, it would take 12.5 years to double the value of your investment (\$100 collected in dividends + \$100 of invested equity).

Similarly, for a company with a P/E ratio of 10 selling at \$100 per share in market (i.e. the EPS is \$10) – if the company continues to earn \$10 per share in net income every year and returns this as dividend to shareholders, then the investor would be able to double the investment in almost 10 years time.

Needless to say, value investors look for relatively lower P/E ratios while evaluating when to invest in the company. Lower the P/E ratio, earlier the chance of earning back your capital. Do note that if the company doesn’t pay out 100% dividends as assumed in illustration above (most companies rarely do), it means that the net income is invested in other projects which might provide better returns and hence, a better chance of growing your capital faster. This is where knowing ROE and ROIC comes in handy for an investor.

Do we need to compare P/E ratio with anything? We should do two basic checks before investing in the company, assuming we like the company after analysing the fundamental factors discussed in previous chapters:

• How does the P/E compare with overall market? If it is higher than the overall market (say S&P 500 Index for comparison with a US stock), we should probably refrain from investing in that company.
• How does the P/E compare with other companies in same industry? If the P/E is higher than the peers, it is worthwhile to check the fundamentals of peers to understand whether the quality of business of the company in question is much better than the peers or whether there are higher expectations of growth in the future (and hence higher price to buy the stock).

Chapter 21 – Valuation concept (P/B ratio)

Chapter 19 – Cash flow statement (2)

## Chapter 19 – Cash flow statement (2)

Lets take a look at a sample cash flow statement to go through this discussion. I am choosing a company familiar to almost everyone reading this article: Coca-Cola

(all numbers in USD mm, source: Morningstar.com)

Some observations from Coca Cola’s 5-yr cash flow statement:

Operating cash flow: As you can see, the cash from operating activities has been around \$10bn for the last 5 years even though the Net income in the range of \$6bn-\$9bn. The difference comes from the change in working capital (Current assets – current liabilities) and non-cash expenses like depreciation recognised in income statement.

Investing cash flow: In earlier chapters, I said that Depreciation is a real cost even though it is considered as a non-cash expense. This can be seen in the Net cash from Investing activities. The first 2 lines showing Investments in property, plant and equipment demonstrate the ongoing yearly cash outflow by the company to either maintain the properties or upgrade the plant so that they can continue to operate at current output level. This also shows that Depreciation of assets on the Balance sheet (recognized at initial cost) is not able to capture the real cost of upgrading/replacing assets, as the actual cash outflow in the Investments in property, plant and equipment has been consistently higher than the depreciation number used in Income statement. Hence, the cash flow statement provides a better view of requirements for running the business. It is can also be useful to see the trend of percentage of investment in plant, property and equipment to the net income over the years. This gives us an idea of total capital expenditure requirements for the company.

From the other investing activities of Coca Cola (Purchase of Investments and Sales/maturities of investments), we can infer that most of those movements correspond to cash equivalents on Coca Cola’s balance sheet recognized as liquid investments.

Financing cash flow: Coca Cola has been issuing more debt than the maturing debt. Since it is a company with strong earning power (seen from the operating cash flows), it seems to be leveraging the business over the years, adding \$2bn-\$5bn of debt every year. On top of this, it has been paying out hefty dividends to the shareholders along with net stock buybacks, both activities loved by the shareholders. Even though it does seem like the company is being shareholder friendly, increasing amount of debt can be painful if the interest coverage falls with decline in operating cash flow. Before investing in the company, I would go back to balance sheet to see the amount of leverage (Debt/Equity) and to income statement to check Interest coverage ratio (EBIT/Interest expense). Finally, whether the Return on Capital is more than the cost of debt (ROIC).

Questions to ask from any cash flow statement:

• Are the operating cash flows able to fund the investing activities for the business? What proportion of net income is spent in investment in property, plant and equipment every year?
• What is the disparity between depreciation and actual expenses to maintain the business?
• Is the company issuing more capital via equity or debt? Is it good for shareholders?

Chapter 20 – Valuation concept (P/E ratio)

Chapter 18 – Cash flow statement (1)

## Chapter 18 – Cash flow statement (1)

Coming to the final financial statement that we look at while analysing a company – Cash flow statement. This statement shows the actual cash inflow and outflow for the period under study. We can visualize it as the sources and uses of cash for a business. It is categorised under 3 main headings:

• Cash from Operating activities: This section shows the actual cash generated by the business from its operating activities, i.e. main business operations. For the hot dog owner, that would be total cash generated from selling hot dogs minus his cash outflow for ingredients, advertising, rent, salaries of staff etc.
• Cash from Investing activities: This section primarily shows the cash used/received from investing in/liquidating assets of the business and upgradation of machinery or infrastructure. For the hot dog owner, this could mean buying more stalls, more kitchenware, more tables, buying a new shop and so on.
• Cash from Financing activities: This section shows the total change in cash from payment of dividends, raising more capital (by issuing more stock or debt), buying back stock from market (resulting in Treasury stock), paying off debt etc. Effectively, this section involves the change in cash position due to financing from banks and capital markets.

We are concerned mainly about the cash from operating activities and cash from investing activities. The reason is – for a stable or a healthy business, normal operations should be able to generate enough cash for existing business as well to fund the expansion activities. If not, then the business would dip into Financing activities involving banks and capital markets which can result in dilution in stake of existing shareholders or taking on more debt. Also, to have access to capital markets for more capital (debt or equity), the business would need to show a good underlying business opportunity, else who would be really interested in investing? It does not mean that a company with troubled underlying business is not able to raise capital – it just comes at a higher price!

Why is cash flow statement different from the income statement?

Good question. Two major reasons:

• Revenues: In accounting, the company can record revenues when the sale contract is signed. But the cash from this contract may not come until next year. So even though we see increase in revenues, we will not see the corresponding cash to hit the bank account. Remember the cash cycle we discussed in Chapter 10 where a part of revenues is captured as Receivables on the Balance sheet. Those receivables become cash when the customers pay up for the sale of products.
• Investments: As a business invests in new assets, only a portion of the cash flow is recognised in Income statement using Depreciation (as discussed in Chapter 4). The cash flow statement helps us to understand the actual cash outflow for new investments in plants or property recognized at 100% of cash outflow.

A Cash Flow Statement can be constructed using a Balance Sheet and Income Statement together. We are not going to have that discussion here, as it would be a part of an accounting discussion rather than an investing discussion. But we will talk about some sanity checks or potential red flags when looking at a cash flow statement in the next Chapter.

Chapter 19 – Cash flow statement (2)

Chapter 17 – Key ratios

## Chapter 16 – Leverage

Leverage basically refers to borrowing money at cheaper rate to invest in assets with higher rate of return, thus resulting in a profit. If the business conditions stay good, this can result in a good profitable situation for the business owners. However, if the investment turns out bad, it might end up in a result which is not so good from an owner’s point of view. Let’s run through two scenarios for the hot dog owner:

Scenario 1 (with debt): The hot dog owner has \$50,000 to start his business. Let’s say he borrows another \$50,000 @ 10% per year (i.e. an interest expense of \$5,000 per year) to setup the business in double the size since he believes that there is a good opportunity to earn more money by setting up 2 shops. Assume both shops are setup in two malls with similar footfall i.e. similar number of customers visiting every year. Assume cost of goods sold and SG&A to be constant at \$40,000 per shop. Assume profits to be taxed at 25%.

Case 1: Business is great and both shops make \$70,000 per year

Case 2: Business is not so great, a new pizza chain opens shops right next to both hot dog shops and kills the sales. So the total revenues are now \$80,000 (\$40,000 per shop).

Scenario 2 (without debt): Here, the hot dog owner opens only one shop with his equity of \$50,000. Assume cost of goods sold and SG&A to be constant at \$40,000 per shop. Assume profits to be taxed at 25%.

Case 1: Business is great, shop makes \$70,000 per year

Case 2: Competition from pizza shop drives the revenues down to \$40,000 per year

In the above examples, we have made the numbers such that the Case 1 for both Scenarios show a jolly picture of business while Case 2 shows the worst case scenario for the business. Let’s try and understand the economics of leverage now:

As you can see, when the business is doing well, taking some loan actually increased the amount of net income available for hot dog owner. His return on equity increased from 45% to 82.5%. So leverage can amplify returns in good times. However, take a look at the scenario when business is not doing well. Without debt, the business makes no profit. But with debt, the hot dog owner has to pay interest on top of the expenses, leading to a net loss. So the net return on equity worsens from 0% to -10%.

Hence, it is always good to analyze the amount of debt carried by a company. There have been instances where the companies used a lot of leverage and could not pay back the loans resulting in creditors taking control of the assets and liquidating the business, thus leaving nothing for the owners.

Chapter 17 – Key ratios

Chapter 15 – Shareholders’ equity

## Chapter 15 – Shareholders’ equity

This section of the balance sheet represents the total value that is attributable to the owners (shareholders), after deducting all the obligations of the company, i.e. what portion of the assets is left for the shareholders after the company pays all its dues – to creditors (banks, bond holders), employees (pensions and salaries), taxes (accrued tax) etc. Thus, it is shown as below in mathematical form:

Shareholders’ equity = Total assets – Total liabilities

A lot of sub-headings come under this category, such as – Common stock, Retained earnings, Treasury stock and Other items (could be various form of reserves set aside by the company). As an investor, we are mainly concerned with the following two categories:

• Retained earnings: This line item shows the accrual of reinvested income over the years. Let’s say a company makes a net income of \$50k in the 1st year and distributes \$10k to the shareholders as dividend. Remaining \$40k is reinvested in the business, and this amount is added to the Retained earnings. In the second year, net income grows to \$80k, out of which \$30k is distributed to the shareholders. The remaining \$50k is reinvested in the business, thus increasing the Retained Earnings to \$90k (\$40k + \$50k) by end of second year.
• Treasury stock: When a company starts buying back its shares in the market, it gets the shares back. Now it can either choose to keep them as Treasury stock in Equity section, or just cancel them out completely. Keeping them accounted for gives a flexibility to re-issue shares later to raise more capital if needed. If the shares are not cancelled, they sit on the company’s books as Treasury stock. These shares neither have any voting rights and nor any right over the earnings of the business, i.e. when the net income per share is calculated, these shares are excluded from the calculation. Do we like to see Treasury stock on the balance sheet? Yes, if the management buys the stocks back at a price lower than the intrinsic value of the business or, if the management thinks that it can’t deploy the excess capital in a manner that would increase the return for the shareholders. If the management is not able to find good projects to invest in, it can decide to return cash to the shareholders via dividends or share buybacks. Share buybacks are usually more tax-efficient way of returning cash to the shareholders, hence many investors like to see companies buying back shares.

Please note that sometimes a portion of reinvested capital can be accounted for under various categories within the Shareholders’ equity section. Some of these earnings can be allocated FX exposure buffer, which is there just to prevent loss from currency fluctuations effecting the business activities. All in all, what we really want to see is that the retained earnings and other buffers have been increasing consistently.

The value of Treasury stock can significantly lower the value of shareholders’ equity as it is carried in the balance sheet as a negative number. For such companies doing share-buybacks, you can add back the value of Treasury stock to remaining shareholder’s equity to see the trend of shareholders’ equity over the years.

Chapter 16 – Leverage

Chapter 14 – Long term debt and other liabilities

## Chapter 14 – Long term debt and other liabilities

Long term debt: Money borrowed by a company for more than one year is called long term debt. The reasons to issue long term debt could be either of the following:

• Funding long term assets: When the company has to setup factories and other infrastructure which has a certain cost and can’t be repaid in one year’s time from the yearly operations, the company borrows money for a longer term so that it can pay off the debt in small intervals (much like the house loans taken by individuals which they expect to pay off in coming years from the income).
• Funding acquisitions: When a company wants to buy out another company but doesn’t have enough capital to do it on its own, it borrows money from the market to acquire another company and pays off the debt in small steps using the cash flows from the business of existing operations and the acquired company.
• Leveraging the business for higher returns: It is important that we talk about the concept of leverage and how it can increase the returns for a business owner or even have a negative impact on the financial position. This concept applies to overall debt (short term debt + long term debt) and will be discussed in the chapter after we learn about Shareholders’ equity.

Other non-current liabilities are usually not significant to spend time on. These may relate to some taxes to be paid or other obligations.

Chapter 15: Shareholders’ equity

Chapter 13: Current ratio

## Chapter 12 – Current liabilities

As discussed in the Balance Sheet basics, liabilities refer to the obligations of a business. Current liabilities are the obligations due within one year timeframe. Major items under current liabilities are as follows:

• Payables: This is when a business buys some goods or services on credit. Let’s say our hot dog business owner buys the ingredients from a grocery store with a promise to bill to pay within 30 days. In this case, hot dog owner will record this transaction as a Payable on the company’s balance sheet while the grocery store will record it in Accounts receivables.
• Accrued expenses: These are the expenses incurred by the business but not yet paid out. Typically staff salaries, marketing expenses, which are billed, say monthly/quarterly etc. come under this category.
• Short term debt/loan: This is the loan taken by the company to meet its short term cash requirements, i.e. to buy the inventory for production of goods. As the inventory is sold, the company pays back the loan and repeats the cycle. Other uses of this cash could be payment of bills or anything which is required to keep the business running.
• Long term debt due in 12 months: As the name suggests, the company borrowed money for a tenor greater than 1 year at some point in past, but as of the reporting date the company has to pay it back within 12 months.

For the short term debt, I would also check whether it is used to finance long term assets. If it is doing so, that is red flag as it can potentially pose problems when the liquidity dries up in the market, in other words, when the banks stop lending due to worsening business conditions or other factors. It can also negatively impact the P&L if the interest rates are going up – more the interest rates for rolling over the debt, lesser is the profit left for the business owners.

Other current liabilities, if any, would ideally not be significant enough to worry about.

Chapter 13: Current ratio

Chapter 11: Non-current assets

## Chapter 8: Income before tax, Tax expense and Net Profit

Income before tax (EBIT) = Operating profit – Gain/loss on sale of assets – Other items

Tax expense – It is simply the tax owed by the company to the government

Net Profit = Income before tax – Tax expense

Net Profit is the widely watched item when the earnings results are announced for a company. Whilst growth in absolute numbers is good to watch, it is also advisable to see this number as a percentage of Revenues, i.e. what percentage of Revenues in the concerned period was actually translated into profit that the owners of the company could use for themselves or invest it back in the growth of the company. This measure is called Net Profit Margin (%), expressed as below:

Net Profit Margin (%) = Net Profit/ Revenues

As would be obviously clear by now, more the net profit margin, the better investment it would be.

Please see below the example for Gilead Sciences (GILD) to see the trends of profit margins. Except for a period between 2012 and 2013 when margins dropped to late 20s (which also is arguably very good), the company has been able to maintain margins above 35%.

Chapter 9 – Balance Sheet basics

Chapter 7 – Other items

## Chapter 7 – Other items

Gain/loss on sale of assets: There are times when a company decides to sell its assets which could be investments in securities or land or a part of business to a competitor who is willing to pay a good price. Since these do not form a part of major operating activities of most businesses (except financial institutions and real estate companies), these should be excluded from ascertaining the earnings power of the business.

It is worth mentioning that some companies might window-dress their income statements by not putting the Gain on sale of assets separately from the operating income section. Value investors would be careful not to get fooled by such practices.

Other items: Other sources of income other than the ones mentioned above are not directly contributing to the earning power of the business, so should be excluded.

Investors should be very careful if these items form a major part of profits, year after year.

Chapter 8: Income before tax, Tax expense and Net Profit

Chapter 6 – Interest Expense