Fundamentals

# How Stock Fundamentals are Derived from Company Financials Part 1: Balance Sheet

December 29, 2012

Value investors are very interested in the fundamentals of the companies they invest in, particularly historical data over the past 5 – 10 years. These days it’s easy to go to any of dozens of websites and pull up fundamental data such as EPS, P/E Ratios, Debt/Equity Ratios, and virtually any other metric you can think of simply by entering a ticker symbol. But where does this data ultimately come from?

The answer is that it comes from the company financials which are reported annually and quarterly in the form of a balance sheet, income statement, and cashflow statement. Why do we care? Well there’s two problems that the company financials can help us solve. First, most of the websites that provide this pre-calculated fundamental data, only do so for the current year. If we want to know what the debt/equity ratio was 8 years ago for example, we need to look at the company financials. That brings up the second problem. If you look at the financials, you won’t find the same metrics we’re used to seeing. Most of the fundamentals we’re used to seeing are actually derived from various line items on the financial statements, and to a non-accountant it’s not always immediately obvious which ones to use!

This post is the first of a three-part series, in which we’ll look at company financial statements line by line and derive the fundamentals we’re used to and love. Today we’ll look at the Balance Sheet.

## An example: IBM

It will be easiest for us to work through an actual example rather than speaking in the hypothetical. Let’s choose IBM to work with. IBM’s most recent annual report (2011) can be found here. We’ll also need to pull up IBM’s fundamental data to compare the numbers to what we derive from the balance sheet. Let’s use Morningstar – IBM’s fundamentals as calculated by Morningstar can be found here.

The annual report is quite lengthy, but luckily we’re only interested in one small portion of it. To confuse things, IBM doesn’t calls their balance sheet a “Consolidated Statement of Financial Position“. It can be found on page 72 of the 2011 annual report and is shown below (click to enlarge).

We can recognize this as the balance sheet from the key information it contains. Balance sheets always have line items for Total Assets, Total Liabilities, Total Equity, and Total Liabilities and Equity. Sidenote: The reason why it’s called a “Balance” sheet, is because the sum of liabilities and equity must always be equal to (or balance with) total assets. If we look at IBM, we see that it does – \$116,433 million in this case.

Now let’s pull up the Morningstar data. Check out the screen shot below (click to enlarge).

## Guide to Deriving Fundamentals from the Balance Sheet

Now we’ll run through all of the common stock fundamental data than can be calculated using information available on the balance sheet. Some of the calculations will require the use of a stock price. We will attempt to use the stock price that was trading at the time the report was issued so that we can compare numbers if possible.

Important note: The calculated numbers found on stock research websites often don’t agree with each other. The numbers we calculate below might not agree perfectly with the numbers found online.

### Debt / Equity Ratio

A company’s Debt / Equity ratio (D/E) is a measure of the relative proportion of shareholder’s equity and debt that is used to finance a company’s assets. Company’s with a very high amount of debt can be at a larger risk for financial default, so this ratio is sometimes used to gauge the financial health of the company. A check on Morningstar show’s that IBM’s D/E as of the 2011 annual report was 1.14. It was calculated with the following equation:

`$D/E = displaystylefrac{text{Total Liabilities}}{text{Shareholder Equity}}$`

If we look at the balance sheet, we see that IBM’s total liabilities are listed at \$96,197 million and total shareholder equity is listed as \$20,138 million. Therefore we calculate D/E as follows:

`begin{align*}D/E &= frac{96,197}{20,138} \ &= 4.78 end{align*}`

But wait – this doesn’t equal the Morningstar number of 1.14! That’s because the D/E ratio listed on most stock websites actually calculate a slightly modified ratio based on long term debt only, more accurately called the Long Term Debt / Equity Ratio (LT D/E). The D/E we calculated above includes all of the liabilities that are current, such as taxes, bills, benefits etc. The LT D/E is usually more useful to investors, and is calculated slightly differently:

`$text{LT D/E} = displaystylefrac{text{LT Debt + Current Portion of LT Debt}}{text{Shareholder Equity}}$`

Long term debt is listed on the balance sheet as a separate line item for an amount of \$22,857 million. Current portion of long term debt is the interest and principal payments that are due on the LT debt within the next 12 months. Because, it’s current it’s actually listed under current liabilities instead of long term liabilities. To complicate things further, IBM has chosen not to show this as a separate line item on the balance sheet, but instead refers us to Note J, where they explain that the current portion of long term debt is \$4,306 million. We can now calculate:

`begin{align*}text{LT D/E} &= displaystylefrac{22,857 + 4,306}{20,138} \ &= 1.35end{align*}`

Let’s compare this with the morning star data:

It doesn’t match! This is the common problem with the financial websites. They use slightly different numbers to come up with their calculated Fundamentals. What Morningstar hasn’t done is take into account the current portion of LT debt. They’ve simply calculated LT D/E as follows:

`begin{align*}text{LT D/E} &= displaystylefrac{22,857}{20,138} \ &= 1.14 end{align*}`

Now the numbers match, but this is why being able to understand the balance sheet is a useful skill to have. You can look at the raw data and make decisions as to which information is relevant.

### Current Ratio

A company’s current ratio is a measure of its ability to pay off its current liabilities (due in the next 12 months), with short term assets (cash, inventory, receivables). The calculation is as follows:

$text{Current Ratio} = displaystylefrac{text{Current Assets}}{text{Current Liabilities}}$

From the balance sheet we see that current assets are \$50,928 million and current liabilities are \$42,123 million. This calculates to:

`begin{align*}text{Current Ratio} &= displaystylefrac{50,928}{42,123} \ &= 1.21end{align*}`

### Quick Ratio

Quick ratio is very similar to current ratio, and is a measure of a company’s short term liquidity. There are two methods to calculating it. One of them considers that it’s possible a company may not be able to sell all of its inventory to cover its short term debt obligations. This often considered a shortcut. The second is a more conservative approach that only considers truly liquid assets, and is sometimes called the acid-test ratio.

$QR = displaystylefrac{text{Current Assets - Inventories}}{text{Current Liabilities}}$

or

$QR = displaystylefrac{text{Cash + Short Term Investments + Accounts Receivable}}{text{Current Liabilities}}$

Let’s look at method 1 first. Current assets and liabilities can be found from the balance sheet as \$50,928 and \$42,123 respectively. Inventories is listed as its own line item for a value of \$2,595 million. We now have enough information to complete the calculation:

begin{align*}text{Quick Ratio} &= displaystylefrac{50,928 - 2,595}{42,123} \ &= 1.15end{align*}

Now let’s look at the more conservative approach with method 2. Cash & cash equivalents is listed on the balance sheet as \$11,922 million. Accounts receivable is split into two lines, one line for Notes and accounts receivable for an amount of \$11,179 million, and another line item for Other accounts receivable in the amount of \$1,481. Short term investments isn’t immediately obvious, but it is actually the line item called Short-term financing receivables in the amount of \$16,901 million. We can verify this by look at Note F.

begin{align*}text{Quick Ratio} &= displaystylefrac{11,922 + 16,901 + (11,179 + 1,481)}{42,123} \ &= 0.98end{align*}

Morningstar uses the conservative method 2 to calculate quick ratio, as shown in the following screen shot:

### Book Value

Book Value (BV) generally refers to the sum of all of a company’s assets minus its liabilities. It’s the price that a buyer would pay if the company were to go bankrupt immediately, as future earnings etc. would no longer be a factor in determining the price of the company. Book Value is calculated as follows:

$BV = text{Total Assets - Total Liabilities}$

Book Value isn’t typically listed on most stock quote websites including Morningstar, but it is used in some of the other calculations we’ll look at next. Total assets from IBM’s balance sheet are \$116,433 million and total liabilities are \$96,197 million:

begin{align*}BV &= 116,433 - 96,197 \ &= 20,236 end{align*}

But wait – the number we just calculated is the exact same number as Total Equity on the balance sheet! That’s because book value and total assets mean the same thing. Things are rarely that simple however, and this is one of those cases. True book value or total assets is rarely used in most of the calculations we require for stock evaluation. True book value includes intangible assets and goodwill, both of which could very well be worth nothing if the company were to go bankrupt. Therefore, a related metric called Tangible Book Value (TBV) is sometimes used and calculated as follows:

$TBV = text{Shareholder Equity - Goodwill - Intangible Assets}$

We can find a goodwill amount of \$26,213 and intangible assets worth \$3,392 listed on the balance sheet as separate line items. We then calculate tangible book value as follows:

begin{align*}TBV &= 20,138 - 26,213 - 3,392 \ &= -9,467 end{align*}

In other words, once we take goodwill and intangible assets out of the equation, IBM’s liabilities exceed its remaining assets! This number doesn’t show up on Morningstar, however if we go to Yahoo Finance, this number is calculated at the bottom of the balance sheet (click to enlarge):

### Book Value per Share

The more commonly found variation of book value is on a per share basis – or more specifically, a per common share basis. Stating book value per share allows for a comparison between companies with differing numbers of outstanding shares:

$BVPS = displaystylefrac{text{Stockholder Equity - Preferred Equity}}{text{Total Outstanding Common Shares}}$

Total Equity is listed on the balance sheet and can be pulled off as \$20,138 million. Preferred equity isn’t shown however. Not every company issues preferred stock, but in IBM’s case they have in the past, but it’s listed under note L in the accompanying documents. In note L, it’s stated that there are 150 million shares of preferred stock, with a \$.01 par value each. The catch though is that none of the preferred stock is outstanding. Stock can be classified as follows:

1. Authorized stock is the amount of stock that the company is allowed to sell.
2. Issued stock is stock that has been sold, and includes both the stock that’s currently being traded on the open market, as well as stock that the company has bought back through share buyback programs (referred to as treasury stock) and stock that has been retired.
3. Outstanding stock is the amount issued stock that is still being openly traded on the market. By this definition, it does not include treasury or retired stock.

Since none of the preferred stock is outstanding, it doesn’t carry any equity value and is therefore not included on the balance sheet. For our purposes of calculating the book value per share then, preferred equity equals zero.

The final number we need is the total number of outstanding common shares. This number is included on the income statement, under the heading Weighted-average number of common shares outstanding. Under it, there’s a basic number of 1.196 million, and an assuming dilution number of 1.214 million shares. We want the diluted number of shares for our calculation.

begin{align*}BVPS &= displaystylefrac{20,138,000,000 - 0}{1,213,767,985} \ &= 16.59end{align*}

Note that our number does not match up with the number from Morningstar, but it’s relatively close. Book value and book value per share vary quite a bit between sources due to the number of shares chosen to use in the calculation.

### Price / Book Ratio

The Price / Book ratio (P/B) is a measure of how expensive the stock price is compared with it’s underlying assets. In general, it’s a measure of how much an buyer would pay for the company if it were to go bankrupt immediately. It is calculated as follows:

$P/B = displaystylefrac{text{Stock Price}}{text{BVPS}}$

If we want to compare the P/B with the price listed on Morningstar for the date the annual report was based on (Dec. 31, 2011), we need to use the stock price from that time which was \$183.88. BVPS was calculated in the previous section to be \$16.59.

begin{align*}P/B &= displaystylefrac{183.88}{16.59} \ &= 11.1 end{align*}

## 4 thoughts on “How Stock Fundamentals are Derived from Company Financials Part 1: Balance Sheet”

1. I found your description of various stock fundamentals to be very interesting. Personally I perfer to look at other indicators to gauge a stock’s future performance, but I definetly look at a company’s balance sheet before I buy.

1. Thanks very much Brett. Yes, there’s plenty of other indicators I use as well and will be writing about them shortly. Which ones do you use?

2. My personal favorite investing metric is the PEG ratio. I always use this ratio because I am a huge fan of Peter Lynch.