3. What is a Balance Sheet and Margin of Safety Video Lecture | Become an Expert: Value Investing - Business Basics

welcome to course 1 unit 1 lesson 3 what
is a balance sheet and margin of safety
in this lesson we have four lesson
objectives the first is to understand
the importance of a balance sheet the
second is how do you determine the
equity of a business
the third is understand that accompanies
margin of safety and the fourth is
business value a comparison of net
income and equity so let's get started
let me warn you that if you're starting
this lesson out without seeing lesson 2
you're probably going to be a little bit
behind so I'm recommending that you go
back and view the course 1 unit 1 lesson
2 a video before jumping into this
lesson 3 okay so where we left off in
lesson 2 was that we had a small
business owner who whose name was Nancy
you can see here there at the top and
she had this small ice-cream business
and the ice cream business had $100,000
in revenue and as it went through all
the different costs she eventually ended
up with 20,000 dollars of net income or
earnings and we we know that that that
term that income in earnings is a very
important figure to understand because
that's the amount of money that's left
after the entire business model and
Nancy had two options she could keep
that money for herself she could pay
herself or she could put the money back
into the business we had talked about in
the in the previous lesson
what Nancy's business was worth so let's
assume that Nancy wants to sell her
business she she doesn't want to own it
anymore she wants to sell it and she's
asking $200,000 for somebody who buy it
so that that's her market price whenever
a person sets that price that doesn't
necessarily mean that they're gonna get
$200,000 for the ice cream stand but
that's what she's asking for we we
realized that whenever she's making
$20,000 in that income that you'd have a
10% return if she's asking for $200,000
for the business but how safe is that
investment that's really the question we
got to understand at this point to go
forward so off to the balance sheet is
where we're gonna have to figure that
out any business any corporation has
three pieces of paper that they have to
account for all all the things that
their business operates the first ones
the income statement the next one's the
balance sheet the third one is the cash
flow statement and I have a little
where they're representing each one of
these documents so for Nancy's business
she has an income statement now if you
look below the income statement you see
the little model that we use from lesson
two below that because that's what we
were doing we were figuring out
essentially what her income statement
was it starts at the top of that income
statement is the total revenue and the
bottom line figure at the bottom of that
document of the income statement is the
net income so we pretty much already
understand the income statement and
that's used to find what the company's
profits going to be now something that
we haven't talked about is the next one
which is the balance sheet if you look
in the middle there there's the balance
sheet and we can use the balance sheet
to determine the margin of safety that
you would get if you were to purchase
this business from Nancy who's asking
$200,000 for her business just just so
you know the cash flow statement is
something that we're not going to cover
until course to the overall courses that
the website teaches so don't worry about
the cash flow statement right now I just
really want to focus on two documents
there the income statement and a balance
sheet you absolutely have to know all
three of these documents that is
something that as a stock investor you
are going to have to become very
familiar with all three of these
documents so there's only three of them
you need to commit those the memories so
just remember that the income statement
the balance sheet and the cash flow
statement if you're taking notes I would
definitely write those three documents
down so what we're going to focus on
right now is the balance sheet and this
is used to determine our margin of
safety among some other things too so
what is the balance sheet the best way
to understand what the balance sheet is
is to ask yourself this question what
would happen if the business would
liquidate right now okay now I use the
fancy term there liquidate but all that
all liquidate means is that you're going
to basically turn the entire company
into cash meaning you're going to end it
you're going to kill it
that's another word for liquidate is
that you're gonna kill the business she
was gonna liquidate her business what is
it worth right now not ten days from now
not ten days ago it's right now that's
how you have to look at that that
estimate so in order to do that you have
to basically sum up all of your assets
sum up all your liabilities and then the
difference when you when you subtract
the liabilities from the assets
is your equity so let's demonstrate that
so here what I did is I just took a very
generic balance sheet for Nancy's
business her ice cream business when on
the top you can see I have the total
assets okay so I'm gonna go through
these real quickly the cash in the
account so Nancy has a corporate bank
account that's different than her
personal bank account and in that bank
accounts she has three thousand dollars
on hand her ice cream stand let's just
say the ice cream stand is worth ten
thousand dollars let's say the ice cream
machine let's say she has a real fancy
ice cream machine inside it's worth
$5,000 on the supplies that she has on
hand right now as a thousand and the
land that she bought the put her little
ice cream stand on is twenty five
thousand dollars so when we sum up those
assets its forty four thousand dollars
so now let's look down at the total
liabilities so the first thing we see is
the salary owed to her employee of two
thousand dollars so she has to pay that
out she hasn't paid her yet the next
thing is the ice cream stand itself now
you'll notice that I listed the ice
cream stand up in the assets and I also
listed the ice cream stand in the
liabilities on the top it's ten thousand
dollars on the bottom it's nine thousand
dollars the reason that that the ice
cream stand is listed twice is because
she hasn't paid for the ice cream stand
so although the ice cream stand is worth
ten thousand dollars she's only paid off
a thousand of it so she only owns a
thousand dollars of that ice cream stand
the other nine thousand dollars she
either hosed the bank or whoever lent
her the money in order to buy it so we
just learned something about Nancy's ice
cream stand here is that she doesn't
necessarily own that that stand itself
she owns a thousand dollars of it of the
whole $10,000 worth of the ice cream
stand so then we look at the ice cream
machine
and we have the same exact thing the
machine might be worth $5,000 but three
thousand dollars of that is still death
because Nancy doesn't own the ice cream
machine she took out a loan in order to
buy it so she owns two thousand dollars
of the five thousand dollars okay and
then we look at the land so she would
have bought that plot of land for in the
land is worth twenty five thousand
dollars what she's listing
but she still owes $23,000 on that land
so she's only paid off $2,000 on that
land so when we sum up all her
liabilities we see that Nancy owes
$37,000 on this ice cream stand so when
what we've got to do is we just take the
assets we take those total assets we
subtract the total liabilities and we
see that Nancy's equity in this business
and the equity is just the difference
between those two is 7,000 dollars so
this sheds a whole lot of light on
Nancy's ice cream stand you know it
might be making twenty thousand dollars
a year in profit but the only thing it's
worth on the books right now which is
her balance sheet and if you look up in
the top left there the balance sheet the
equity is only seven thousand dollars on
this business so in order to get a
better idea of a balance sheet I often
encourage people to sit down and try to
determine their own equity with a
balance sheet you know sit down with a
blank piece of paper and write down all
your assets you know write down how much
you have in cash a plant in your bank
account write down how much you think
your car is worth right now and you have
to say what it's worth now not what you
bought it for how much you think your
house is worth and then go down to the
liabilities and then start listing how
much do you have in credit card debt how
much is your loan for on your house how
much is your car loan still and then
list all those things then what you do
is you just add up your assets subtract
your liabilities and see what your
personal equity is and when you do that
you're really going to have a better
idea of what a balance sheet actually is
because you've done it firsthand okay
and something one final thing I want to
highlight here is you look up on that
balance sheet in the top left the equity
is for the whole business when you value
the entire business when we start
talking about shares one share the the
terminology that's equivalent to equity
is Book value so whenever I slip up and
say Book value I'm actually saying
equity but Book value is per share
that's equity per share okay so now
we're going to look at here if Nancy
couldn't find a buyer for her for her
I scream Stan how much is her business
worth okay we said that you know if we
valued it at $200,000 it's going to give
her it's going to give her or the person
who would buy a 10% return but if no
one's willing to buy it for that how
much is it really worth if she just
wanted to end this business and she
couldn't sell it to anybody how much is
she gonna get and the answer is her
equity she's going to get $7,000 for
this business so you saw a business it
went from you know her trying to sell it
for maybe $200,000 but if she can't find
a buyer and she just wants to kill the
business and sell her ice cream machine
and pay off her debts and all that she's
only going to have $7,000 left at the
end of the day so this difference
between what of the market price of what
a person's asking for and the actual
equity that's sitting in the company
that difference is the risk that's the
margin of safety and this was Benjamin
Graham's big thing which we learned was
Warren Buffett's professor at Columbia
his big thing was margin of safety if a
business didn't have a substantial
amount of safety between what the market
price was and what the equity was he was
very hesitant to ever buy a company so
like in this scenario the equity is
actually three and a half percent of
what the market price is and you know
that that's no that's no safety at all
because let's say you'd buy this
business for $200,000 let's say you
bought it okay there you are with your
ice cream stand and it's it's making
that that net income that you saw which
was twenty thousand dollars and as it's
making that all of a sudden your
employee quits and sales start
decreasing and all of a sudden you're
not making money anymore and you have to
sell the business what is the business
worth well it's worth the equity so
there you are that there that's all the
risk that's wrapped up into this company
is that difference between the market
price of which you buy it for and how
much the equity is for the company on
its balance sheet and as you can see the
closer the equity is to the market price
the the safer the investment so as we
look at this slide right here I laid out
the two things we've already talked
about the income statement that's what
we learned in lesson two and now you see
the balance sheet which we learn about
in this lesson
so the net income off of the income
statement was $20,000 a year therefore
if you're buying that business for
$200,000 you can expect return of 10% on
your money but that's only if the
business operates like it's supposed to
that's that's if all the customers keep
coming that's if all your employees
don't quit or change that's if your ice
cream machines never break or your you
know you don't run into any issues you
don't have any lawsuits any of that
stuff okay that's what the business
would be worth but as we go over there
and we look at the balance sheet in the
equity is only $7,000 that is that is a
lot of risk that you have and so the
margin of safety is really low on this
investment the equity is 3.5% of the
market price so you're looking for
something that would have equity you
know if the equity in the business was
150 thousand dollars and your net income
was twenty thousand dollars you'd
probably have a very easy time you know
asking $200,000 for the business but in
this case I think she's going to be
having a very hard time finding a buyer
at $200,000 when there's only seven
thousand dollars of equity in the
business okay so I'm going to quickly
jump ahead the the thing I really wanted
you to get out of this was understanding
what the term equity was and also
understanding what margin of safety was
so if you got that out of this lesson
that's what we're really shooting for
I'm just going to give you kind of a
glimpse of what's to come ahead here so
if this confuses you don't worry about
it just go to the next lesson you should
be fine
okay so we're if you remember from
lesson two I and I want you to look at
the $20,000 in that income I told you
that the owner has the option to do two
things they can either pay themselves or
they can put that money back into the
business and if she pays herself that's
a dividend when you're dealing with
stocks and when you put that back into
the business I said that it could
potentially be retained as earnings so
when we look at this I put the balance
sheet off to the right hand side there
let's assume that Nancy took that
$20,000 and she was putting it back into
the business opposed to paying herself
you would actually see her equity
hopefully if she's making wise decisions
by paying off her debt at this point
based off her balance sheet you would
see that her
when he would increase by that $20,000
if she's making payments straight to her
to her debts so that's what you'd like
to see so did her earning power increase
by very much maybe a little bit because
she might have made some wise
investments maybe a new machine or
whatever but generally speaking she's
probably gonna still be making about
$20,000 a year but what did change is
that her equity would have probably gone
from seven thousand seven thousand
dollars up to twenty-seven thousand
dollars if she put all of it in there
through one year's period so what would
she would she would have done is she
would have reduced her her risk she
would increased her margin of safety
because her equity would have increased
in the business that her net income
would probably still be generally close
to the same so that's something to kind
of look at and if you didn't understand
that that's fine you're going to get
plenty more as we go along so that's
just something to think about as is
we're looking at this scenario very
early on we can already start to see how
some of this stuff is going to be
playing out so the four things that we
learned in this lesson we learned about
understanding the importance of a
balance sheet and we understood how to
determine the equity of a business we
understand the company's margin of
safety and we understand the business
value of comparison of the net income to
the equity so I hope you learned a lot
and I'll see you guys in the next lesson