Most investing stories focus on company earnings. How much a company can earn in the future. How much a company has earned the past. What value (in the form of a price to earnings ratio) the market should put on those earnings. Today we’re going to change tack and focus on balance sheets instead.

Earnings come from a company’s income statement, a document showing the firm’s revenue and profits (or losses) generated over a period. By contrast, a balance sheet shows a company’s financial position – what it owns and what it owes on a certain date.

A strong balance sheet can give a company strategic flexibility. It can also reduce downside risk and make a company’s stock more attractive. I’ll cover a few reasons for this soon. But first let’s define what I mean by a strong balance sheet.

What makes a balance sheet sound?

Instead of asking what we’d like to see on a balance sheet, let’s use Charlie Munger’s inversion technique and ask what we don’t want to see.

The main thing you don’t want to see is an unsustainable level of debt. By unsustainable, I mean a level of debt that is too high relative to the company’s cash flow or the nature of its industry. Most successful companies can sustain some debt, and this can help them grow faster than using equity financing alone. I wrote about studying a company’s debt load here.

If a company carries too much debt, a downturn in business could mean they start struggling to keep up with interest and debt repayments. In extreme cases, it could lead to bankruptcy. But in almost every case, it will reduce the flexibility management has to create value for shareholders. They might have to cut back on investments they need to make in the business. They might not be able to make an attractive acquisition during an industry downturn. Et cetera.

What we’re looking for, then, is an absence of liabilities that could threaten the company’s survival or reduce management’s ability to act strategically. The famous value investor Marty Whitman used to talk about seeking companies that are ‘eminently creditworthy’.

Why I love strong balance sheets

My basic investment approach is to buy good businesses that are out of favour due to short-term pressures. Not all of my holdings have flawless balance sheets. But I view a healthy balance sheet as a big positive for three reasons.

1. A healthy financial position increases the chances a company will make it through the rough patch they are currently in.

2. It also gives a company the flexibility to keep investing in growth while competitors are pulling back. For example, by acquiring one of these competitors at a knock-down price.

3. On the flip side, a healthy balance sheet could make my investment attractive to acquirers. This is because they would be able to borrow more to fund the deal. I might not actually want the company to be taken over. But it does increase the number of ways I can win.

On that note, here are three ASX shares with sound balance sheets that are currently undervalued versus our analysts’ estimate of Fair Value.

3 undervalued ASX shares with strong balance sheets

Before we get onto the names, here is a quick explainer of some terms you might see used:

Net debt: Total debt minus cash and cash equivalents. This adjusts a company’s borrowings for how much cash it has to hand. If a company has more cash than debt, this will be negative and is called a “net cash” position.

EBITDA: Earnings before interest, tax, depreciation, and amortisation. This is often used as a measure of how much cash a company can direct to servicing debt each year.

Net Debt to EBITDA: A ratio comparing net debt to cash available to service debt. In essence, this ratio tells you how quickly (in years) a company could pay off all debt using earnings.

Ansell ★★★★

Ansell (ASX: ANN) is a leading manufacturer of protective wear for healthcare and industrial markets.

Ansell’s revenue is split across approximately 40% industrial and 60% healthcare products. Each market is quite fragmented and Ansell’s market share varies by subsegment, but the firm has consistently held the highest or second-highest global market share in its key verticals. Competitors differ between the two segments but are either divisions of large global players or regional companies.

According to our Ansell analyst Shane Ponraj, the company’s balance sheet is in sound condition - even after it announced the acquisition of Kimberly-Clark’s (NYS: KMB) protectivewear business for USD $640 million in April 2024. Ponraj forecasts this to increase Ansell’s Net-Debt to EBITDA ratio to a peak of 2x in 2025, up from 0.5x previously. This still seems fairly conservative. Although Ansell’s industrial segment is exposed to global economic cycles, financial risk looks low given the company’s solid cash conversion and relatively low gearing.

Ponraj thinks Ansell has a narrow moat. This stems mainly from Ansell's brand equity, which allows it to successfully compete in the more specialized protective glove markets. This has helped Ansell maintain its leading market positions and led to average returns on capital of over 11% over the past five years. He thinks the global protectivewear market can grow in the low-single digits, driven by improved workplace safety but partially offset by increasing automation. The largest growth opportunity is industrial emerging markets where a large proportion of workers still do not use protective gloves.

Against this backdrop, Ponraj has assigned Ansell shares a fair value of $32 based on 4% average revenue growth and a recovery in operating margins to around 17%. Ansell has a Medium Morningstar Uncertainty Rating. While its healthcare segment earnings are fairly resilient, its industrial segment is exposed to global economic cycles. Also, new capacity built to meet pandemic-induced demand may compete with Ansell’s more differentiated products as pandemic demand subsides. Ansell shares currently trade at around $25.

Kogan ★★★★★

Shares in online retailer Kogan (ASX: KGN) shares have suffered as it grapples with muted consumer demand. But it remains financially strong with around $50m in net cash as of December 2023. This strength helped the company reinstate its dividend in February 2024 having paused it in 2021. In the past, it has also allowed Kogan to make opportunistic acquisitions.

In fiscal 2019, furniture retailer Matt Blatt made $47 million of sales with $10m of that sold online. In May 2020 in the depths of Covid-19, Kogan bought the business for just $4.4 million. Kogan also bought Dick Smith’s online assets – including its large customer database – out of administration in 2016. For just $2.6 million, they secured a new online channel that has been a material source of earnings ever since.

Morningstar’s Johannes Faul doesn’t believe that Kogan has an economic moat. There are low switching costs for customers to comparison shop and Kogan is seeing more competition from Amazon and omnichannel retailers. Kogan’s initial cost advantage from sourcing direct from manufacturers and selling online eroded as the practice became widespread. And while its 4 million and rising customers across Australia and New Zealand make Kogan’s platforms valuable to third-party brands and advertisers, they are far from achieving a dominant network effect.

Despite this, Faul still expects Kogan to achieve high returns on capital due to the structural tailwind of e-commerce growth, the ramp up of its marketplace, and being a capital light business by nature. He projects group revenue to grow by an average of 5% per year over the next decade with a big uptick in EBITDA margins from 1% to around 10%. Faul assigns Kogan a fair value of $10.70 per share with an Uncertainty rating of Very High. This reflects the potential for intense competition and the cyclical nature of selling non-essential goods.

IDP Education ★★★★

IDP Education (ASX: IEL) is a global leader in education services, providing English language testing and teaching, student placement services, digital marketing, and education events.

The English language testing business is IDP’s largest business segment, comprising 64% of fiscal 2022 revenue. Student placement services is IDP’s second-largest business segment, comprising 27% of fiscal 2022 revenue. Over the decade prior to the COVID-19 pandemic, IDP’s student placement services business has also been IDP’s main engine for growth, with growth primarily coming from India as a fast-growing source country and the United Kingdom and Canada as fast-growing destination countries.

Morningstar’s IDP analyst Shane Ponraj thinks IDP’s balance sheet is in sound condition. Financial risk is low given its current net cash position and IDP’s main businesses having below average exposure to economic cycles. He forecasts IDP to maintain its net cash position over the 10-year explicit forecast period, while also funding planned increases in capital expenditure on IT and maintaining a 70% dividend payout ratio.

Ponraj has assigned IDP a narrow moat due to network effects in its English language testing business. As part-owner of International English Language Testing System, or IELTS, IDP operates one of the world’s most widely accepted English language tests for access to education institutions, professional bodies, and visas. As IDP is granted more licensing rights as an English proficiency certifier, the IELTS certification itself becomes more valuable for its wider acceptance and thereby attracts additional prospective students, employees, and migrants. This incentivises additional education institutions, employers, and migration authorities to accept the IELTS certification to tap into large pools of prospective students, employees and migrants. I wrote about other ASX shares that benefit from network effects here.

IDP shares fell heavily recently as management guided to lower English testing and student testing volumes. Ponraj adjusted his fair value estimate for IDP down by around 8% to AUD 22.50 per share, but the shares still look undervalued at around $14.50.

This is based on average revenue growth of 9% per year through fiscal 2028, driven by English language testing and student placement services. He thinks that IDP can reap higher margins as the more profitable student placement business grows as a percentage of overall revenue. Ponraj gives IDP an Uncertainty rating of High. As a facilitator of migration, IDP faces risks from deglobalisation and government decisions to limit migration and places for foreign students. While IELTS is a valuable network asset, there is a risk that co-owners the British Council and Cambridge Assessment terminate key licensing agreements and impair the network effect.

Terms used in this article

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.