How to invest in stocks: What to look for when evaluating companies

The balance sheet tells you how much a company has in assets, such as cash, the investments it holds, and also items such as receivables — money it’s due to receive from customers. It also tells you how much the company has in debt. The “balance” in balance sheet is the comparison of assets to debts.

A couple of very important aspects of a business can be gleaned from the balance sheet. The first is the current ratio, also known as the working capital ratio. Working capital is the money a company has on hand to cover its obligations. It’s an exercise in asking, If a company stopped making money today, would it have enough assets to cover what it has to pay out? A company with a higher current ratio has a stronger balance sheet, and is better able to cover its obligations.

Current ratio

The current ratio is calculated by dividing current assets by current liabilities. Among the highest current ratios of all S&P 500 companies is home builder D.R. Horton (DHI; $72.86). It has a current ratio of 4.9. That makes sense, given that Horton has a lot of value in current assets locked up in what’s known as inventories, items such as construction in progress and land, both developed and undeveloped. Those are assets that help offset its obligation to deliver homes. 

On the other hand, a company such as discount chain Dollar General (DG; $248.73) has among the lowest current ratios, at about one times current assets to current liabilities. Dollar General has very little cash, with most of its assets being merchandise it holds in its stores. At the same time, it owes a large amount in any given period to the suppliers of its merchandise, and the two things just about cancel each other out. You could conclude that Dollar General operates with much less of a cushion than Horton.

Enterprise value

Another important finding from the balance sheet is what’s known as a company’s enterprise value. Remember our market capitalization that we mentioned above? That’s normally used as the total value of a company if you added up all of its shares. But if a company has a lot of cash, or a lot of debt, you’ll need to adjust market capitalization to reflect that. 

A company with lots of cash is less expensive than its share price alone would suggest, because you’re getting a share of that big cash pile with every share of stock you buy. Conversely, a company with a lot of debt will be more expensive than share price alone would suggest, because you’re taking on the responsibility of that debt with every share you buy. 

To find enterprise value, take the market cap and subtract the dollar amounts for cash, and add the dollar amounts for debt. Take D.R. Horton again as an example. In late July the company had a market capitalization of $25 billion. But because it has more debt than cash — $4.26 billion versus $1.68 billion — its enterprise value, at $27.8 billion, is higher than its market cap of $25 billion by more than $2 billion. Horton is more expensive when you calculate enterprise value.

Dollar General, with considerably more debt than cash, has an even bigger gap between its market capitalization and its enterprise value — it’s way more expensive on the latter basis than you’d think from just checking stock price.

Enterprise value adds sophistication to valuation analysis in other ways. Remember our price-to-sales and price-to-earnings from the income statement? An investor who wants to be more sophisticated than average will look beyond those two metrics. They will take enterprise value and use that number instead of market capitalization to divide by sales or by earnings. The ratio is no longer price-to-sales, it’s now “EV-to-sales” or “EV-to-profit.” You can also combine enterprise value with our discussion of free cash flow from the cash flow statement, and arrive at “EV-to-free-cash-flow,” and really be sophisticated. 

For example, Apple, you’ll recall, has a P/E of 30, more expensive compared with its S&P 500 brethren. But, with almost $179 billion in cash and investments, Apple has more money than most entities on the planet. If you want to be really sophisticated, you’ll use Apple’s enterprise value, which takes into account that cash, and divide it by the company’s trailing 12 months of free cash flow. On that basis, Apple has an EV-to-free-cash-flow of 25 — still pricier than the S&P, but not as much of a premium as it appeared based on straight P/E.

In this way, if someone tells you something looks cheap, you may want to ask what it looks like when EV is used, to reflect whether cash or debt affects the valuation.

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