Property, Plant and Equipment on the Balance Sheet
Investing Lesson 3 - Analyzing a Balance Sheet
One of the most useful lines on a balance sheet in terms of understanding how asset intensive it is and the specific business model it follows is property, plant and equipment, or PP&E. Property, plant and equipment represents the so-called "fixed assets" of an enterprise; the real estate, buildings, office furniture, file cabinets, computers, factories, vehicles, and other tangible things that allow it to conduct operations in pursuit of generating revenue and, ultimately, a profit.
Generally, property, plant and equipment cannot be converted into cash quickly. If it can, it usually is at a price nowhere near the figure carried on the books. Rather, the real value lies in its ability to productively serve the enterprise. An illustration might help you understand this important concept.
Property, Plant and Equipment Is Almost Always Most Valuable When Productive Not When Sold
Think of an incredible business like Colgate-Palmolive. It has been operating since Thomas Jefferson was in the White House. It's made a lot of buy and hold investors exceedingly rich and had a steadily growing dividend for generations. The products make life better for billions of people, dominating their respective niches (in some places, such as rural India, Colgate sometimes comes near holding an astounding 80% market share). To put it in perspective, despite already being one of the most respected blue chip stocks in the world, if you had bought $100,000 of shares in the firm on the day I was born back in 1982, you'd now be sitting on approximately $7,285,450, of which $5,928,985.20 came from your 82,210 shares of the stock and $1,356,465 from cash dividends collected over the years.
That doesn't even assume any dividend reinvestment, which, had those dividends been plowed back into buy more shares of Colgate-Palmolive, you'd have been in the eight-figure range as a result of the extraordinary power of compounding.
At of the end of fiscal year 2015, the Form 10-K showed $3,796,000,000 in net property plant and equipment. (The "net" refers to the fact that many balance sheets list the fixed assets on a net basis so, rather than showing you the gross fixed assets and the accumulated depreciation separately, they show you the former subtracted by the latter.) If Colgate-Palmolive tried to sell that off in an auction, it would receive only a tiny fraction of that amount. The real source of value doesn't come from the machines.
It's not in the equipment. Instead, it's in the company's franchise value. You could have the exact same property, plant and equipment and you wouldn't be able to do much damage to Colgate-Palmolive because it has centuries of lead time in getting people to trust its products. You'd need the intellectual property, too; the brand name, the trademarks, the trade secrets.
Excellent Businesses Almost Always Have Low Property, Plant and Equipment Relative to Cash Flow Flow and Net Earnings
Over the years, I've talked quite a lot about what it means for a firm to be an excellent business. One of the hallmarks of an excellent business is that it generates high returns on capital that are sustainable. That leads to more owner earnings - profits that can be extracted from the business without hurting its competitive position. It also offers a built-in protection of purchasing power when inflation comes rearing its ugly head because it takes fewer dollars outlaid to upgrade equipment at the end of its useful life.
In fact, some of the very best businesses you'd want to own don't require any property, plant and equipment at all. My husband and I own a company that has a contract with a manufacturing plant. We created an e-commerce solution that solved a lot of its problems. In exchange, we received the right to an on-going cut of the revenue generated by this firm. The business through which we hold this contract, a limited liability company, has no property, plant and equipment. It collects cash throughout the year and we distribute it to ourselves, as the equity owners, for use elsewhere.
That's far preferable than having to pay for all of the machines, building upgrades, computers, and other fixed assets ourselves. Economically, our business is superior because we get the joys of ownership without the risks, holding a type of synthetic equity in the manufacturing firm.
When analyzing the balance sheets of companies in a particular sector or industry, be sure to compare the relative property, plant and equipment of the firms relative to a dollar of after-tax profit generated. If one or more of the businesses is a lot more productive, that can be a sign to look more closely as it could turn out to be a fundamentally superior enterprise.