There are many things to look for when evaluating a stock—and one of the most important is hidden assets

For a long time we’ve written about the “heads-you-win, tails-you-break-even” phenomena. That’s what you get in an investment that exposes patient investors to limited risk of long-term loss, but one that can deliver healthy if not substantial returns.

These situations sometimes come about when a stock has been an unimpressive or weak performer for a number of years. When that happens, investors often focus on the earnings weakness and lose sight of the company’s assets.

If you buy a stock for its hidden assets, but those assets stay hidden or ignored by investors— or turn out to be less valuable than you thought—it can’t hurt you much. By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price.

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Hidden assets in real estate

For instance, when a company buys real estate, the purchase price goes on its balance sheet as the historical value of the asset. Over a period of years or decades, the market value of that real estate may climb substantially. But the purchase price remains unchanged on the balance sheet.

You have to look closely to spot this hidden value. At times, the hidden value in a company’s real estate can come to exceed the market value of its stock. This hidden value may only become apparent to investors when the company upgrades the use of the real estate. For example, a merchandiser might repurpose a parking lot to build a shopping mall with a residential condo tower on higher floors, and a parking garage down below.

You may recall that Canadian Pacific Railway was something of a dullard in the stock market of the 1980s. But it became a huge winner for us in the 1990s and 2000s, when it put its real estate and other hidden assets to more profitable uses.

Hidden assets in retail

Companies may have a hidden asset in their relationship with a clientele of loyal customers. After a series of satisfactory dealings, long-time customers develop a level of trust that makes them receptive to related offerings from the company. For example, Apple Computer was able to move into the digital music player and smartphone businesses as quickly as it did in the past decade because it had an established core of fans for its Mac computers.

Seek out hidden assets early

The best time to find hidden assets is when they’re still hidden, long before the company begins taking steps to profit from them. Understanding and seeking out hidden assets while you’re evaluating a stock can add enormously to your profits in the course of an investing career. But you need patience to profit from them, because they can stay hidden for a long time after you buy.

Hidden assets can also cut your risk. Stocks with hidden assets are likely to hold up better than those whose assets are easier to spot, since they are the last stocks that experienced, successful investors sell. When times are good, on the other hand, stocks with hidden assets tend to do better than average. Good times give them opportunities to put their hidden assets to work.

Looking beyond hidden assets to uncover value

Stocks with hidden assets are not rare, but they’re hard to find. But when you know what to look for, you can discover them.

Here are three financial ratios we use as a guide to evaluating stocks, especially value stocks, which often have hidden assets.

1. Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. As a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents excellent value. We calculate each p/e ratio using the most recent financial data. But we also analyze the “quality” of the earnings. For instance, we disregard a low p/e ratio if it is due to a one- time capital gain on the sale of assets, since the gain temporarily bloats the “e”. (That shrinks the p/e.) Similarly, we add back any one-time earnings write-offs, so we don’t miss out on bargain stocks that would have had low p/e ratios if not for one-time write- offs. You need to remember that a low p/e can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to view p/e ratios in context. Instead, we check to see if other financial ratios confirm or contradict their value.
2. Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. This ratio represents a “snapshot” of an instant in time, and could change the next day. Asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. (Certain types of assets on a balance sheet might have actual market values well above historical values, as sometimes happens with real estate or patents.) When we are evaluating a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often when evaluating a stock, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, and at risk of being written down.
3. Price-cash flow ratios: Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays. Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. Cash flow is particularly useful in valuing companies in industries in which depreciation and depletion charges are based on the historical value of assets instead of current values—industries such as oil & gas and real estate. As with any financial ratio, you always have to look at it in context.

Have you developed a knack for evaluating a stock and finding valuable hidden assets on balance sheets? What are some cues that spark your interest? Share your insight with us in the comments.

Note: This article was originally published in March 2015 and has been updated.