In Part II of this educational series on value investing, which I published back on October 4th, I introduced you to some of the specific methodologies that I use to uncover quality value candidates. These include the use of advanced screening tools, as well as an analysis of each firm's income statement.

In today's article I'll bring you Part III of this educational series. In it, I'll take a closer look at how to analyze a firm's cash flow statement and balance sheet. I'll also summarize many of my methodologies and will show you how you can use them to uncover highly undervalued stocks...

Cash Flow Statement
The Cash Flow statement is undoubtedly one of the most overlooked -- yet at the same time also revealing -- of all the financial statements. While earnings can be manipulated by aggressive accounting techniques and distorted by non-cash adjustments, the cash that flows into and out of a business is more transparent. To many, free cash flows (cash from operations less capital expenditures) are the best indication of a company's profitability. After all, free cash flows represent the amount left over that is "free and clear" for management to use to repurchase shares, pay dividends, or reinvest back in the business.

While the income statement yields such measures as Price/Sales (or Enterprise Value/Sales), Price/Gross Profits, and Price/Earnings, the cash flow statement gives us Price/Cash Flow and Price/Free Cash Flow. If these ratios are not keeping pace with Price/Earnings, then the company's earnings quality may be called into question. Finally, this statement gives investors a window to peer into a company's share issuance and repurchase activities.

As the name implies, the line item labeled "sale/purchase of stock" provides investors with a summary of a firm's stock purchases or sales. A negative number on this line typically means that management has reduced its number of outstanding shares through the use of stock buybacks. Meanwhile, a positive number is a sure sign that shareholder dilution is taking place -- most likely from the issuance of stock options. Even if the number remains level, it may not necessarily be a positive for stockholders, as sometimes cash is used to repurchase the same number of shares that have been handed out to executives. Fortunately, in the near future most firms will be required to list stock option expenses on their income statements.

Balance Sheet
As we get to the balance sheet, it is time to ascertain the company's financial health. Here we will be examining the firm's cash and liquid investments, its long-term debt, its receivables, and its liabilities.

One of the first things I do with the data found on the balance sheet is adjust the company's price per share to determine its enterprise value per share. Here is a relatively simple example:

Company XYZ
Current Price = $5.00
Cash = $3.00
Long-term debt = $1.00
Accounts Receivable = $0.75
Liabilities = $0.25

To calculate Company XYZ's enterprise value per share, first begin with the current stock price of $5.00 per share. From there, subtract the cash on hand of $3.00, and then add back debt of $1.00. These first steps leave us with $4.00. Next, subtract receivables of $0.75 and add liabilities of $0.25. After doing so we arrive at a final adjusted price of $3.50 per share.

Nearly all of the companies I profile in my biweekly newsletter, Margin-of-Safety Investing, have an enterprise value well below their market capitalization -- meaning their cash and accounts receivable far exceed their debt loads. In fact, many of the firms I've selected for my model portfolio have stockpiled large amounts of cash and have zero long-term debt on the books.

Another trait I look for on the balance sheet is a relatively high PPE/Market Cap ratio. In many cases, companies with large PPE (property, plant, and equipment) balances own valuable real estate that is recorded at historical cost. Often, the true value of these assets is substantially higher -- and somewhat hidden. Of course, before investing I also always take a closer look at the firm's latest 10k filing to glean additional information about each property's purchase date and location. These items can sometimes provide clues as to their true market value.

Next, I dig a little deeper to ensure that the equity section of the company's balance sheet is clean. This is a crucial step, as even impressive earnings and sales growth can be watered down by excessive warrants, preferred stocks, convertible debt, debentures, and other potentially dilutive securities. I also tend to be leery of firms with dual-class share structures.

Next, I like to take a closer look at the intangible asset balance. In particular, I recommend reading each firm's 10Q filing to gain a better understanding of goodwill. Growing goodwill can be troublesome, as the amount could eventually lead to a major expense on the income statement and cut into future earnings. Intangible asset balances are an ideal place for clever accountants to hide expenses on the balance sheet in an effort to overstate earnings. Therefore, keep a close eye on rising intangible asset balances, as they could be an early warning sign that management is attempting to mask expenses.

When analyzing accounts receivable, one of the most important tasks is to ensure that an increasing receivables balance is matched by a corresponding rise in sales. If accounts receivable are growing faster than sales, then it could be an indication of aggressive accrual accounting. Inventory balances should also generally not be rising at a faster rate than sales for a prolonged period of time. Soft assets like prepaid expenses should remain stable, as this account can hide transactions that belong as an expense on the income statement.

Finally, I calculate every stock's Price/Book and EV/Book ratios. These all-important metrics should be stacked alongside market averages and similar industry peers.

Putting It All Together:
Whenever I uncover a stock that compares favorably to its competitors in all of these diverse categories, it becomes a serious contender for my portfolio. However, more work must still be done. The financial statements are a great place to begin searching for undervalued stocks, but there are other factors that should also be weighed carefully. 

To begin, there are a number of small, but important, clues that can either reinforce my opinion or persuade me to look elsewhere. For example, I have found that little or no institutional ownership can often be the hallmark of an undervalued company. Furthermore, a stock's recent movements can also be telling, particularly when compared to those of close competitors. Stocks have been statistically shown to demonstrate "mean regression." As a result, companies that have been lagging for an extended period of time may be due for a rebound.

Also, the importance of a firm's management team cannot be overstated. One way to gauge its performance is through ROE (return on equity), which is a major driver of shareholder value. Examining ROE requires investors to dig deeper at the variables that underpin the calculation, such as profitability, capital structure, productivity, and the value of intangibles.

Finally, an investor must have a firm grasp not only on the numbers themselves (which are in a state of constant change), but also the factors that drive those numbers -- market share, public image, brand loyalty, patents, pricing power, etc.

Ultimately, everyone should let their individual personality dictate their investing strategy. Some investors like to roll the dice on a handful of carefully chosen stocks, while others prefer to hold a broadly diversified portfolio. Some will have no trouble maintaining a long-term outlook, while others will lack the right temperament to sit on a slow-moving, deeply-discounted stock while the rest of the market surges forward.

There is no single correct way to search for value stocks. With this in mind, rather than blindly following someone else's system, I suggest you choose a method that is aligned with your goals and beliefs. Regardless of the strategy, you should make sure not to let fear, greed, and emotional reactions influence your investing decisions. Whatever method you select, if you can manage to avoid shortcuts, do your homework, and also be patient, then good results will come.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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Thanks for reading!

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