Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Nvidia (NVDA) in order to get some clues as to how well this company is doing.
I will go through the balance sheet, reviewing the most important items, in order to assess Nvidia's financial condition. The information that I am using for this article comes from the company's website here.
Note that this article is not a comprehensive review as to whether Nvidia should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.
Nvidia is a visual computing company that is committed to connecting people through the powerful media of computer graphics. It has long been known for creating graphics chips that are used in PCs to bring video games to life. PC gamers use its graphics processing units (GPUs) to enjoy immersive fantasy worlds.
Nvidia's processors today are used in everything from mobile devices to supercomputers. Its GPUs are used to create visual effects in movies, as well as in supercomputers for applications such as virus simulation, weather forecasting and oil exploration. The company's Tegra processors are used to power smartphones, tablets and automotive infotainment systems.
Nvidia sells its processors to original equipment manufacturers (OEMs) that build PCs, workstations, servers, smartphones and tablets. Of the company's fiscal 2013 sales, 32% came from Taiwan, 19% came from the U.S., 18% came from China, and 18% came from other countries in the Asia-Pacific region. Europe accounted for 6% of sales, while 7% came from other countries in the Americas.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
As of July 28, 2013, Nvidia had $2.93B in cash and short-term investments, which can be easily converted into cash. Short-term investments account for $2.34B of this position. These investments consist of U.S. Treasuries, U.S. agency debt, corporate debt, money-market funds, and mortgage-backed securities that are backed by government-sponsored entities. This is a lot of cash for a company with a $8.94B market capitalization. This means that the company is trading at just over 3 times its cash position, which may make the stock very attractive to value-oriented investors.
Over the last 12 months, Nvidia repurchased approximately $897M worth of stock. In 2007, the board authorized a buyback program worth $2.7B. As of now, there is still $286M remaining on it until December 2014. The company has also paid out $89.6M in dividends over the last 12 months. It just started paying out dividends in November 2012. This is a good sign for growth and income investors. The company generated $661M in free cash flow over the last 12 months.
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
Nvidia had a total of $418M in net receivables on its balance sheet, which represents 9.86% of its trailing 12-month sales of $4.24B. For fiscal 2013, 10.6% of its sales were booked as receivables, while that percentage was at 8.4% for fiscal 2012.
Given that receivables currently account for a relatively small percentage of sales and that this figure is somewhat consistent, I don't see anything to be alarmed about here.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
The current ratio of Nvidia is 4.19, which is outstanding.
Property, Plant and Equipment
Every company, regardless of the industry in which it operates, requires a certain amount of capital expenditures. Land has to be bought, factories have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant and equipment, as companies that constantly have to upgrade and change their facilities to keep up with competition may be at a bit of a disadvantage.
However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors. Right now, Nvidia has $579M worth of property, plant and equipment on its balance sheet. This figure is inline with the $576M that the company reported at the end of fiscal 2013, and slightly above the $560M that it reported at the end of fiscal 2012. Of these assets, 27% is in test equipment, while 19% is in software and licenses, 17% is in land, 14% is in computer equipment, and 12% is in leasehold improvements.
Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case-by-case basis, as good companies are rarely purchased at or below book value.
Nvidia has $641M worth of goodwill on its most recent balance sheet, which is the same as it reported 6 months prior, as well as at the end of fiscal 2012.
Overall, goodwill accounts for about 11.5% of Nvidia's total assets. Usually, I don't like to see goodwill account for more than 20% of a company's total assets for the reason that I discussed at the beginning of this section. Since Nvidia is well below this threshold, I don't see much to be concerned about here.
Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto its assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.
Nvidia currently has $323M worth of intangible assets on its balance sheet. This is inline with the $312M that it had 6 months prior, as well as the $326M that the company reported at the end of fiscal 2012. Of these assets, 79% is in patents and licensed technology, while 21% is in customer relationships and in-process technology. All of these assets have finite lives.
While the eventual loss of $323M from the balance sheet is not a good thing, considering that amount accounts for less than 6% of the company's total assets, I don't see anything to be alarmed about here, going forward.
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:
Return on Assets = (Net Income) / (Total Assets).
For Nvidia, the return on assets would be $708M in core earnings over the last 12 months, divided by $5.57B in total assets. This gives a return on assets for the trailing twelve months of 12.7%, which is decent. I also calculated Nvidia's returns on assets over fiscal years 2013, 2012 and 2011 for comparative purposes. This can be seen in the table below.
Table 1: Returns On Assets At Nvidia
The numbers shown in the above table are decent returns on assets, and they show that management is doing a good job at making efficient use of what it has as its disposal. These returns have been consistently good over the last 2-3 years. They have been steady over the last couple of years due to core earnings leveling off.
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
This is not a problem at all for Nvidia, as it doesn't have any short-term borrowings at this time.
Long-term debt is debt that is due more than a year from now. An excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.
Right now, Nvidia carries just $17.7M of long-term debt, which is pretty much inline with what the company has reported at the end of the last three fiscal years. Over the last three full fiscal years, the company has averaged $615M in core earnings, which more than dwarfs the long-term debt. With the company's cash position, earnings power, and free cash flow generation, this long-term debt shouldn't be an issue.
In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will often exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company. In this case, I will calculate the debt-to-equity ratio and the return on equity both ways to help give the reader an idea as to how much effect the treasury stock really has.
Nvidia currently has $2.27B in treasury stock.
The debt-to-equity ratio, as normally calculated, is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Nvidia stacks up here.
Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity
For Nvidia, the debt-to-equity ratio is calculated by dividing its total liabilities of $1.40B by its shareholder equity of $4.17B. This yields a debt-to-equity ratio of 0.34.
This tells us that Nvidia is in excellent shape with regard to its debt and equity positions.
However, when you cancel out the negative effects that the treasury stock has on the equity, it gets even better.
In these instances, I calculate what I like to call the adjusted debt-to-equity ratio. It is calculated as follows.
Adjusted Debt-To-Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)
Using the data from the most recent balance sheet of Nvidia, this figure is calculated as: $1.40B / $6.44B = 0.22. The tables below show how both the normal and adjusted debt-to-equity ratios have changed over the last few years.
Table 2: Debt-To-Equity Ratios Of Nvidia
Table 3: Adjusted Debt-To-Equity Ratios Of Nvidia
From these two tables, we can see that Nvidia's debt is very manageable when compared to its equity position. Both ratios are well below 1.0 and have been very consistent. This is great to see when assessing a company's financial condition.
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.
Return On Equity = Net Income / Shareholder Equity
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. However, Nvidia is not one of these companies.
So, the return on equity for Nvidia is as follows:
$0.708B / $36.9B = 17.0%
This appears to be a pretty solid return on equity. In the table below, you can see how the return on equity has fared over the past three years.
Table 4: Returns On Equity At Nvidia
Adjusted Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)
When I strip out the negative effects of the treasury stock, here is what I come up with when using the data from the most recent balance sheet.
Adjusted Return On Equity = $0.708B / $6.44B = 11.0%.
This appears to be a pretty solid return on equity. In the table below, you can see how the adjusted return on equity has fared over the past three years.
Table 5: Adjusted Returns On Equity At Nvidia
Nvidia's adjusted returns on equity have been very consistent and strong.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.
Below, you can see how the retained earnings have fared at Nvidia at the end of each of the last four fiscal years.
Table 6: Retained Earnings At Nvidia
From the above table, you can see that Nvidia has a retained earnings figure of $3.25B, and that it has been steadily growing since the end of fiscal 2010 at a cumulative rate of 71%. This has been happening as the company has been buying back stock and just started paying dividends. This growth is great, as it means that Nvidia has enough money to plow back into the company for more growth.
After reviewing the most recent balance sheet, it can be concluded that there are a lot of things to like about the financial condition of Nvidia. For starters, Nvidia has an extremely good current ratio, which shows that the company has more than enough current assets on hand in order to meet its short-term obligations in the event that its operations encounter an unlikely disruption. Nvidia has solid and consistent returns on assets and equity, showing that management is making efficient use of the assets at its disposal. The company's borrowings are all but negligible, as its earnings dwarf those figures. Retained earnings growth has also been very good, leaving Nvidia with plenty of money to reinvest back into the company for more growth.
While this is not a comprehensive review as to whether Nvidia should be bought or sold, I think that the company is in very good financial condition at this time, with virtually no debt, consistent returns on assets and equity, and cash flow generation. It should also be mentioned that the stock trades at just 3 times its current cash position. As long as it can keep generating consistent returns on assets and equity, while maintaining low debt levels, I remain optimistic on its prospects.
More information on how I analyze financial statements can be found at my website here. It's a website that I created in order to help people make more intelligent financial decisions.
Thanks for reading, and I look forward to your comments.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.