Investors are often confused when they see the balance sheet of a public company and its equity is a very tiny amount as a percentage of total assets, or sometimes, it’s even negative. The question is whether this accounting gimmick is a good or bad sign for companies when making investment decisions. This blog can help investors address such concerns and indicate how investors can distinguish the wheat from the chaff.

1. The good ones – companies that can operate efficiently without equity capital and the case study of many great businesses

The reason for a negative book value is that the company has consistently raised dividends and repurchased shares over the years, and the amount of capital being returned to shareholders is more than the equity capital initially issued in the first place years ago. This is just an accounting record, which becomes less important as the company has grown significantly over the years.

In fact, very great businesses with superb Returns On Equity (ROEs) can run their businesses with negative equity capital without any difficulty in liquidity issues. These companies are few and far between in the public market and usually trade at a premium valuation and the commonalities between these companies include:

• The underlying business has a very healthy cash flow generation, and it made sense for these companies to return all of the cash they have generated and sometimes borrow some (conservatively) to increase dividends or share repurchases to investors.
• These companies have a very favourable cash flow cycle, where they tend to receive cash in advance and pay suppliers much later.
• These businesses tend to have very stable, predictable business volumes, possess pricing power over time and some kind of sustainable competitive advantage.
• These businesses have limited needs for capital expenditures and tend to be considered by the investment community as cash cows.

All these companies consisting of Domino Pizza (DPZ), Lowe (LOW), McDonald’s (MCD), Home Depot (HD), and Dollarama (DOL) have run a negative book value for years. They have been through a tough financial environment like 2008 or the pandemic but still managed to compound capital for shareholders at attractive rates. We don’t think the negative working capital should be a concern for these companies as long as the leverage level (in terms of net debt/EBITDA) is manageable. In addition, ROEs may not be an appropriate metric to evaluate these companies; we think Return on Invested Capital (debt + equity) is a better one for investors to use. Great businesses are the ones that do not need equity capital and can still grow.

2.     The bad ones – the struggling companies investors should stay away from

Negative book value could be a concern for companies if they are unprofitable, cyclical, possessing minimum pricing power and highly capital-intensive. The situation could get worse if these businesses produced losses and secular headwinds in the business model. Consequently, negative equity capital is just a result of the cumulative losses over the years. These companies are the ones investors should stay away from at all costs, no matter how cheaply they trade.

Overall, accounting figures may confuse investors. At the end of the day, what matters to investors is the underlying fundamentals of the business, which would dictate investment results over time. Below we have screened for companies with the following criteria:

• Market cap larger than $50 million
• Return on Equity of at least 30%
• Earnings before interest and tax (EBIT) CAGR in the last ten years of at least 5%
• The company’s track record of dividend growth

The criteria above reflect companies with at least 30% for Return On Equity (ROE), we think this is a really high bar to achieve and we tend to screen for companies that can operate with the need for (meaningful) equity capital. Secondly, we like to see the track record of dividend growth supported by a growth in fundamentals. Therefore, we have screened for companies with EBIT growth of at least 5% per annum in the last 10 years.

The screener results in 14 names within the Canadian equities universe. It is understandable because these criteria themselves are not hard to achieve, however, maintaining a positive EBIT growth while paying most of the earnings as dividends or buybacks becomes a very high bar to achieve consistently.

Members will recognize some of the names that we cover in our Model Portfolios and coverage lists such as Dollarama (DOL), ADF Group (DRX), and Restaurant Brands International (QSR).

Lastly, these companies on the list are not recommendations, but rather a starting point that helps investors generate potential investment ideas.

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Disclosure: The analyst(s) responsible for this report do not have a financial or other interest in the securities mentioned.