Back to Basics, Part 9
Last week, we covered the current ratio, quick ratio, and working
capital, and their relevance to the balance sheet. We'll finish the
series tonight with a few more tools designed to aid in the evaluation
of public companies as an investment.
Enterprise Value is the market capitalization of a company,
plus debt, minus cash and investments. Debt is added because a purchaser of
the company would have to assume that debt in the transaction, and cash and
equivalents are subtracted simply because if you were to buy a company, the
cash and investments coming back to you would in effect reduce the price tag
by that amount.
Enterprise value is a more realistic snapshot of a company's current net value
than market capitalization alone. Because of this, it's a good idea to substitute
enterprise value for market capitalization in the price-to-sales ratio (market
cap divided by trailing 12-month revenues) when comparing how a company is valued
relative to its peers.
Price-to-Book Ratio is calculated by dividing the market capitalization
of a company by its book value. Book Value , (also known as
shareholder's equity) which is calculated by subtracting total liabilities
from total assets, is a rough estimation of the liquidation value of a company.
Price-to-book is somewhat limited in today's world due to the significance it
places on capital assets. Company's such as Intel (Nasdaq: INTC),
which is high on margins and low on capital assets, would seem relatively overvalued
based on price-to-book due to its low book value. The ratio may carry some usefulness
in evaluating companies in the banking, brokerage, and credit card industries,
where takeovers are often based on book value multiples (usually between 1.7
and 2.0 times book), as well as capital-intensive businesses such industrials.
Another problem with price-to-book is that stock buybacks lower book value. This
reflects inflated valuation using this metric, when in fact, value has been enhanced
by the repurchase.
Asset Turns are sales divided by total assets. Comparing present
asset turns with previous quarters or years will tell you if assets are ballooning
in comparison to sales. Assets growth outpacing sales will usually be due to
higher inventories and/or accounts receivables.
Inventory Turns are cost of goods sold divided by average
inventory for the year. Naturally, you'll want inventory turnover to be high.
The more inventory a company has piling up, the less money available to grow
and run the business.
Accounts Receivables Turnover is the sales for a period divided
by the average accounts receivable for that period. This is a measure of how
many times a company clears its books of outstanding credit issued. When comparing
two similar companies, an immediate edge would be given to the one that is
turning over its accounts receivable in a more timely fashion.
Days Sales Outstanding (DSO) is a measure of how many days
worth of sales the current accounts receivable represents. To calculate DSO,
take the current accounts receivable divided by sales for a period over days
in that period. A good measure of credit management, DSO tells us how many
days worth of sales are not yet collected. Obviously, the lower DSO, the better
for a company. Money not frozen in accounts receivable limbo is money that
can be used by and for the business.
>> The Income Statement >>