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Assessing Quality of Assets on Balance Sheet | Understanding Fully Public Companies (Promoters’ Shareholding <20%)

Modified on May 25, 2019

www.drvijaymalik.com has a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. We have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:

  • Can we assess the Quality of Assets on the Balance Sheet?
  • Fully Public Companies with miniscule Promoters’ Shareholding

 

Can we assess the Quality of Assets on the Balance Sheet?

Dear Dr Vijay Malik,

Trust you are doing well!

I have been a passive reader of your blog over the last two years. My stock investing journey started three years back & the process of learning is going step-by-step.

Many people follow many investors investing style. I prefer to follow investing style of “Walter Schloss”. He is an American investor who had primarily invested in low Price-to-Book value companies. I follow the below screener criteria.

 

1) Price to book value <=1

Purchasing companies less than their asset value

Advised reading: How to do Valuation Analysis Of A Company

 

2) Return on capital employed >=9 AND Average return on capital employed 5Years >=9

This article by Nemish Shah inspired me to include this criterion. It is taught from a banking perceptive. If the banks are lending companies, then they should be able to generate capital more than the savings rate).

 

3) Debt to equity <=1

Eliminate debt-heavy companies

 

4) Interest Coverage Ratio >=4

It is the caution from the middle-class mentality. A salaried person should spend 1/4th of his income paying loans and the same logic applies for companies.

 

5) (Operating cash flow 10years) >= (10*Average Earnings 10Year )

Operating cash flow for 10 years should be greater than the net profit for 10 years. This logic I had incorporated from your articles.

Further advised reading: How to do Financial Analysis of Companies

 

6) Unpledged promoter holding >=30

Do promoters have an interest in running the business or else we may face problems like L&T takeover of Mindtree.

 

7) Up from 52w low <=10

Is the stock hitting 52-week low?

 

8) Dividend yield >0

Do promoters think about shareholders?

 

9) Volume >=100

Is there any trading volume for the company shares?

 

10) Contingent Liabilities to Total Assets <=20 AND Contingent Liabilities to Total Assets > 0

I am weary for companies that have too many contingent liabilities. After Nirav Modi scandal, I guess this need to be viewed with a keen eye.

 

11) Net profit >0 AND

12) Cash from operations last year >0 AND

13) (Cash from operations last year > Net profit) AND

14) Debt <= Debt preceding year AND

15) Number of equity shares <= Number of equity shares in the preceding year

The above five qualitative aspects were taken from Joseph Piotroski score. On a 9-point ranking, do they qualify for five ranks at least? Of these, I personally like companies that reduce debt.

The above screener criteria are more of the process of eliminating companies that do not qualify.

Further advised reading: Final Checklist for Buying Stocks

Dr Vijay Malik, I would like to know how you evaluate a company based on its “Quality of Assets”. If you had published articles on this regard, on asset evaluation please let me know.

The idea behind “Quality of Assets” is to assess do we need to make certain adjustments to the balance sheet? For example, companies might be overstating their intangible assets on their balance sheet. This might inflate the balance sheet.

An example of this case is stated by investor Michael Price (click here).

With regard to fixed assets, the below example was quoted by Water Schloss.

“If you have two companies – one with a plant that’s 40 years old and another with a new plant – both plants are shown on the books. However, the new plant may be much more profitable than the old one. However, the company with the old one does not have to depreciate it. So he may be overstating his earnings a little bit by having low depreciation.”

PSU companies might have large parcels of land and building. Do you think they might be underestimating on the balance sheet its value? As an individual investor, I cannot estimate everything. Can we make reasonable assumptions?

I had read an article published by Dr Bruce Greenwald. He had discussed Asset Reproduction Value. Jae Jun from Old School Value had discussed this with an example.

Dr Vijay Malik, all I am trying to understand is with published financial statements & footnotes can I estimate the net worth of the company for the current time. Please let me know your thoughts on this.

Regards,

 

Author’s response:

Hi,

Thanks for writing to us!

You have rightly pointed out that in case of the balance sheet; it is very difficult for any investor to estimate the true worth of assets. It might be a result of the following reasons.

1) Historical valuation of assets like land etc.

2) A significant amount of interest capitalized during debt-funded capital expenditures in the past. Please note that capitalized interest increases the value of the asset on the balance sheet without any addition to the operational worth of the plant & machinery.

Further advised reading: Understand the Capitalization of Interest and Other Expenses

3) Other gimmicks played by management like tweaks in intangible assets, ever-greening of loans by financial institutions etc. An investor would remember that in the recent past, a lot of banks (both public and private) who earlier declared NPA levels of <2% were found to have actual NPA levels of >10% and even going up to 40% (e.g. IDBI Bank).

Further advised reading: Can we assess a Bank’s Financial Position from its Reported Financials?

Such attempts by companies make it difficult to assess the “Quality of Assets” of any company. As a result, we do not give a lot of weight to the parameters based on balance sheet like PB ratio, ROE, ROCE etc.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

 

Fully Public Companies with miniscule Promoters’ Shareholding

Hi Dr Vijay,

I see some of the companies are completely public, means that these companies do not have any promoter holding e.g. ITC Ltd.

I have some question related to it:

  • What is the purpose of making a company fully public?
  • Are there any criteria to make a company fully public?
  • What type of industry can be fully public?
  • As an investor, I prefer a promoter holding of more than 50%. However, in these cases what should we check?
  • Are these companies less prone to corporate governance issues?
  • What are the factors we should check while analysing such companies?

I did some research and found some answers on Google about this. Therefore, here are my views.

It is permissible for companies to have zero promoter holding. The SEBI regulations require a minimum 25 per cent of public shareholding but there is no legal requirement of minimum promoter group holding. There are instances of companies with no promoter holding and therefore, professionals can manage the companies.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

So going to my previous questions:

 

What is the purpose of making the company fully public?

Because it gives the promoters flexibility by doing away with several rules on various matters, including the purchase and sale of shares in the company. Is there any other reason apart from this?

 

Are there any criteria to make the company fully public?

SEBI rules require that the promoters should hold at least 20 per cent of the post-public issue capital and this should be locked in for at least three years. After this, promoters can reduce their stake. For fully public companies, promoters’ stake should be less than 20%.

 

What type of industry can be fully public?

I think companies in any industry can be fully public.

As per your experience, while analysing such companies what type of governance issue can happen as it is fully public. This question needs answer of a 360 view, which I do not have right now. Could you please help me with this?

Regards,

 

Author’s Response:

Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

 

1) Reasons for making a public fully public i.e. promoter shareholding less than 20%:

Apart from the reasons mentioned by you, many times, the promoter may witness their shareholding reducing to very low levels if they have to continuously raise more and more money by equity dilution to run their core business.

A good example of such companies is the start-up world where the business survives because of money poured in by equity investors. Each such round of funding dilutes/reduces the stake of promoters. E.g. in case of Flipkart, the stake of the promoters had declined to single digits before Walmart bought out most of the existing investors.

Alternatively, the promoters may sell their stake in their existing business to fund their other businesses. E.g. one of the reasons Amazon has a low promoter stake is that its promoter has funded his other businesses by selling stake in the public company.

 

2) Governance issues in fully public companies:

We would request you to go through the following article where we have highlighted cases where the management of fully public companies chose to focus more on the share price rather than the core business:

How to do management analysis of companies?

The above article also covers our preference criteria for companies based on promoter shareholding & management succession under the section “9) Promoters’ Faith in the Business”.

All the best for your investing journey!

Regards

Dr Vijay Malik

 

P.S.

 

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above.

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