How to find a balance sheet bargain

How do you spot bargain stocks? Investors often focus on profit-derived ratios, such as the price/earnings (p/e) ratio. But this can be simplistic, and also pretty much ignores one of the most important parts of a company's accounts the balance sheet.

What a balance sheet tells you

A balance sheet lists a firm's assets (what it owns) and liabilities (what it owes). Assets are split into long-term 'fixed' assets and short-term 'current' assets. Take away the liabilities and you get the 'net assets' position (what the firm is worth from an accountant's perspective).

A balance sheet isn't perfect of course. It's a snapshot, so it's out of date by the time a shareholder gets it. Some valuable assets (such as staff) are missing because they are deemed too hard to value objectively. And some liabilities, such as outstanding legal claims, may be hidden 'off balance sheet' in a note if they're hard to quantify. Even so, the published net assets figure is a good valuation starting point. Here follow three tests to help you hunt down some bargains.

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Test 1: price/book-value ratio

One of the best-known balance-sheet ratios compares market price per share to the book value per share. Say a firm has net assets of £20m and has issued ten million shares. That gives a net asset value (NAV) per share of £2 (£20m/10m). If the share price is £2.20, the price/book (p/b) ratio is 1.1 (the share price divided by the NAV per share). The textbook cheap stock will have a p/b ratio of less than one. That suggests you can buy its assets for less than they are actually worth; the stock is trading at a 'discount to NAV'. But this isn't the whole story. As Dylan Grice at Socit Gnrale points out, finding stocks that pass this test isn't easy, particularly after this year's rally. But more to the point, just because something is cheap doesn't mean it's good value. It may be cheap for a reason perhaps it's in a long-term decline. So how can you refine the ratio to make it more useful?

Test 2: residual income

You want to find those companies that can wring the most value out of their assets, says Grice. You also want to make sure you get a better return than you could by putting your money in something safer, such as a savings account. The difference between the future earnings you can expect a firm to generate, minus this 'opportunity cost', leaves what's called 'residual income'. If you add up all a firm's expected residual income from future years, and express it in today's money (by 'discounting' it), you get its intrinsic worth.

If you then compare that 'intrinsic value' to the firm's current market value you get a good indication of whether it's cheap or expensive. So if a stock's intrinsic value is £120m, say, and its market value is £100m, the firm is underpriced. Grice's back testing from 1987 suggests the approach works those developed-market stocks ranked most highly by intrinsic value to price (IVP) "would have returned around 14% more than the lowest" over the period. Sure, intrinsic value calculations are fiddly and riddled with estimates. But, as value investing guru Benjamin Graham once put it: "You don't need to know the exact weight of a fat man to know he should lose weight." Hence his insistence on looking for an IVP greater than 1.5, to build in a decent margin of error.

Using this method narrows down the range of stocks to choose from quite drastically, says Grice. The cheapest sectors on a global basis are agriculture, brewing and insurance. On an individual stocks basis, just 11 companies crop up. One of our favourites is among them, pharmaceutical giant AstraZeneca (LSE: AZN). The list also contains insurance group Aviva (LSE: AV) and brewer Anheuser-Busch InBev (Euronext: ABI). However, the list is topped by Hong Kong-listed food producer Chaoda Modern Agriculture (HK: 682).

Test 3: Tobin's Q

The Yale University economist James Tobin devised the third balance-sheet-testing technique. He believed the best way to judge value was to compare the current market value of a firm with what it would cost to replace it from scratch. If a company could theoretically be set up for less than the market thinks it is currently worth, the share is overpriced, and vice versa. In fact, Tobin said that over- and under-valuations could not last.

On the one hand, if a business's shares are expensive compared to its set-up price, then rivals will soon spring up, forcing the firm to cut prices. That in turn will drag its share price down so that its once-high Q ratio falls closer to one the long-term norm. On the other hand, if a share is cheap compared to its set-up price then it will become a takeover target. Why? Because it's easier and cheaper for potential rivals to buy the company than to expand or set up their own business in the sector.

Accurately estimating replacement cost for a single firm is tricky (how much would it cost to replace a single brand name such as Coca-Cola for example, even assuming that you could?). But Q ratios can also be applied to whole sectors or even markets. And using that measure, the US stockmarket in particular looks overvalued by as much as 40%, says Andrew Smithers of Smithers & Co. Indeed, Grice comes up with an IVP of about 0.7 for the US market, suggesting its market is worth about 70% of its current valuation. So on the basis of balance sheets, US stock markets are clearly to be avoided for now.