MARGIN OF SAFETY & BALANCE SHEETS

In this lesson, we look at the balance sheet of the company. Many investors tend to first look at the income statement since it states how much money the company is making. While this is also very important, the investors should also realize that he is not just buying a cash flow from the company, but also the assets that are producing it. This lesson has the following important points:

1) What is a Balance Sheet: The easiest way to think about a balance sheet is to consider what would happen if the ice cream business would liquidate right now. Imagine that the asset value of the ice cream stand is $10,000, and the debt used to finance the machine is $9,000. The remaining is $1,000, which is called the equity. It’s actually that simple. A balance sheet tells you how much the company owns, how much it owes in debt, and how much the owner would get if the company was liquidated.

2) What is Margin of Safety: This is a very important concept for value investors to understand when evaluating how much they are paying for a business. On one hand in your valuation, you don’t want to pay too much for $1 profit. But on the other hand, you don’t want to pay too much for $1 asset either. The less you pay for an asset, the wider your margin of safety is.

Please note that it might be a tad difficult for you to understand this lesson if you haven’t browsed through lesson 2 yet. I recommend that you go back to course 1, and go through the video found in lesson 2 before jumping into this lesson.

In lesson 2, we had a small business owner named Nancy. She owns a small ice cream business with $100,000 revenue. As it went through all of the different costs, she eventually ended up with $20,000 net income or earnings. Again, net income and earnings, are very important to understand. In case you’ve forgotten, net income or earnings is the amount of money left after an entire business spends money on labor, material, land, and tax.

Now with $20,000 remaining, Nancy has two options. She can either keep that money for herself or she can put the money back into the business. We also discussed what the value of her business was. Let’s assume that Nancy wants to sell her business and therefore asks someone to purchase it for $200,000. Now, remember that this amount is her market price and it doesn’t necessarily mean she’s going to get $200,000 for the ice cream stand. You’d probably have a 10% return if she’s asking $200,000 for the business, but how safe is that investment? We need to understand the question in order to move forward.

Any business or corporation has three documents needed to account for everything their business offers – the income statement, the balance sheet, and the cash flow statement.

Nancy’s business has an income statement. If you look at it, you’ll see the model used for lesson 2. Essentially, we were trying to figure out what her income statement was. At the top of the income statement is the total revenue, while the bottom line figure is the net income. We pretty much already understand the income statement – it is used to find the company’s profit.

Now, we will discuss something new – the balance sheet. The balance sheet determines the margin of safety that you would receive if you were to purchase Nancy’s business for $200,000.

Just so you know, we will not cover the cash flow statement until course 2 but don’t worry about it right now since we will focus on the income statement and the balance sheet for now.

Going back, what is the balance sheet? The best way to understand the balance sheet is to ask yourself this question:
What would happen if the business were liquidated right now?

Liquidation means turning the entire company into cash, which means you’re ending it or killing the business. If Nancy wants to liquidate the business, what is it worth right now? Not 10 days from now, not 10 days ago, but RIGHT NOW. Basically, sum up all the assets and then all the liabilities. The difference between the two is equity. I have provided a generic balance sheet for Nancy’s ice cream business.

Nancy has a corporate bank account which is different from her personal bank account. In that bank account, she has $3,000. Her ice cream stand is worth $10,000. Let’s say she has a real fancy ice cream machine and it’s worth $5,000. The supplies that she has on hand right now are $1000 and the land she bought to put her little ice cream stand on is $25,000. When we sum up those assets, the total is $44,000.

Total Assets:

Let’s look down at the total liabilities. The first element we see is the salary owed to her employee which is $2,000. She will have to pay that if it isn’t paid yet. The next one is the ice cream stand itself. You’ll notice that the ice cream stand is both listed in the assets and in the liabilities. On the top, it’s $10,000 and on the bottom, it’s $9,000. The ice cream stand is listed twice simply because she hasn’t paid for it yet. Although the ice cream stand is worth $10,000, she has only paid off $1000 added. She will either owe the other $9000 to the bank or whoever she borrowed the money from. She doesn’t necessarily own that stand; she only owns $1,000 out of the $10,000.

Now we take a look at the ice cream machine. The machine might be worth $5,000, but $3,000 of that is still debt. Nancy doesn’t own the ice cream machine and she only took a loan to purchase it. She owns only $2,000 of the $5,000.

Next, we go over the numbers on the land. Nancy brought the land that was worth $25,000, but she still owes $23,000. She has only paid off $2,000 for that land yet and when all liabilities are summed up, we see that Nancy owes $37,000 on the ice cream stand.

Total Liabilities:

This sheds a whole lot of light on Nancy’s ice cream stand. Her balance sheet reflects only equity of $7,000 on this business.

To get a better idea of the balance sheet, I often encourage people to just sit down and try to determine their own equity with a balance sheet. Sit down with a blank piece of paper and write down all your assets, including how much you have in cash and in your bank account, how much you think your car’s worth right now, and how much you think your house is worth. Write down its worth NOW, not when you bought it. Go down the liabilities list and then start listing how much you have in credit card debt, how much your house loan is, and how much your car loan is. List all your liabilities. After that, get the difference between your assets and your liabilities to find out what your personal equity is. You will have a better idea of what a balance sheet actually is when you’ve done it firsthand.

Lastly, equity is for the whole business when you value the entire business. We start talking about shares. The terminology equivalent to equity is book value. If I slip up and say book value, I’m actually saying equity since book value is per share, which means that the equity is per share.

Now, if Nancy couldn’t find a buyer for her ice cream stand, how much is her business’ worth? If we valued the $200,000, the person who’s buying it will give her a 10% return. She just wanted to end this business and she couldn’t sell it to anybody. How much is she going to get? The answer, again, is her equity.

Nancy will get $7,000 from this business. You see, she wanted to find a buyer at $200,000 but she couldn’t find a buyer and she only has $7,000 left at the end of the day. Equity is the difference between the market price of what a person’s asking for and the actual equity that’s sitting in the company. That’s the marginal safety and Benjamin Graham’s big thing which we learned from Warren Buffett’s professor in Columbia.

If a business didn’t have a substantial amount of safety between the market price and the equity, Buffett is known to be very hesitant to ever buy a company. In this scenario, the equity is actually 3½% of what the market price is. That’s no safety at all. Let’s say you’d buy this business for $200,000. There you are with your ice cream stand and it is making that net income which you saw was $20,000. All of a sudden, your employee quits, sales start decreasing, and you’re not making money anymore. You have to sell the business. What is the business’s worth? Well, it’s worth the equity. There you are. That’s all the risks that are wrapped up in this company, and that’s the difference between the market price and equity, which is shown on the balance sheet.

The closer the equity is to the market price, the safer the investment. I laid out two things we’ve already talked about in the income statement. Now, you see the balance sheet that we learned about in this lesson. The net income on the income statement was $20,000 a year. Therefore, you’re buying that business for $200,000 with an expected return of 10% on your money considering the business operates normally – customers keep coming back, employees don’t quit, ice cream machine never breaks, any issues, and any losses.

As we look at the balance sheet, the equity is only $7,000, which is a lot of risks. The marginal safety is really low on its investment. The equity is 3.5% of the market price. You’re looking for something that will have equity. If the equity in the business was $150,000 and your net income was $20,000, you’d probably have a very easy time, but in this case, Nancy will have a hard time finding a buyer willing to pay $200,000 because she only has $7,000 equity in the business.

I’m going to quickly jump ahead. I hope you understand the terms “equity” and “margin of safety”. If it’s confusing, just don’t worry about it. Just go to the next lesson.

If you remember from lesson 2, I want you to look at the $20,000 in that income. I told you that the owner has the option of two things: they can either pay themselves or they can put that money bank into the business. If you look at this, let’s assume that Nancy took that $20,000 when she was putting it back into the business when she was supposed to be paying herself. You’d actually see her equity hopefully if she made wise decisions by paying off her debt. You would see that her equity would increase by that $20,000 if she made her payments straight to her debts.

If her earning power increased a lot by making some wise investments in a new machine or something, she’ll probably be making $20,000 a year. However, what changed is the fact that her equity went from $7,000 up to $27,000 if she put all of it in there through one year period. What she would have done is she would have reduced her risk, increased her margin of safety as her equity would have increased in the business.

Her net income would probably be the same. That’s something that we need to look at. If you didn’t understand that, it’s fine. You will get plenty more as we go along.

In lesson three, we explored the importance of a Balance Sheet. We learned that the equity of a business was equal to the total assets minus the total liabilities. After determining a company’s equity, we can use that important number to determine the margin of safety that’s associated with buying a business. The margin of safety is a comparison between the purchase price we buy a business and the equity the business currently has.