Posted by Tim Stobbs on May 23, 2012
So here is a link to the first post in this series, just in case you missed it. In the event, you finger is broken or your just plain lazy here is the 15 second summary of part I: when investing in stocks know why you are investing (income vs growth vs speculation), then determine you own level of risk (bet it all baby, or I NEED that money in five years), and then try to find an unloved stock (one which got beat up by some bad news).
To be absolutely honest that last step of finding the unloved is a nice to have thing. I don’t depend on it as I’ve been know to buy a stock at a higher price if I have some faith that it will still give me a good return on my money. Now that you found a potential candidate of a stock how do you bloody make sense of their annual or quarterly reports? While the following isn’t a ‘cover every damn possible thing guide‘ it should give you a few ideas on what to look at.
The Balance Sheet
First I usually take a quick look at the overall balance sheet of assets, liabilities and equity. In case you have forgotten your high school accounting the only formula you need to know on this sheet is: assets = liabilities + equity. Basically if a company wants to pick up a new asset to help increase earnings it needs to pay for it with either cash, debt aka liabilities, or equity. Equity is a bit of weird one as people tend to forget what the hell it is. In a nut shell if a company sold every last penny of assets and paid all its debts the left over money would be the equity which would then be split up to the shareholders. So if you issue more shares of a company you can raise money with equity rather than liabilities.
Now I skim the balance sheet to get a feel for the assets of the company: how much and in what. Then I take a look at the liabilities and see if the two seem reasonable. There isn’t a hard and fast rule on how this should work as it depends on the business of the company. For example, a utility company tends to have a higher debt load than other business, but it works with large assets over a long lifespan. Yet in general you should see more assets than liabilities. Otherwise I consider that a red flag since a business with more debt than assets can be a sign of something isn’t right. The key words there was ‘can be‘ if a company is in a growth mode it might make sense. Just read the notes that come with the balance sheet and it should explain the obvious questions with the numbers. If it doesn’t, then you have a problem.
Next I skip over to the cash flows summary since I want to understand how much money the business is pulling in and moving out. Let’s face facts here, cash is the life-blood of any company. With out it, kiss goodbye your payroll and then you lose your employees and likely any means of making more money. Financial statement can be confusing to understand, but in general I find the cash flows very useful because it is harder to hide anything in them.
I usually check to make sure that the company is pulling in enough cash from operations to pay out its dividends with a little left over. If not, I want to understand why? Often the cash flow summary will tell you if a lot of money moved into buying more assets last year to help increase future earnings (aka investing). For example, let’s say your company pulled in $70M from operations, but then spent $120M in investing. You might panic for a second until you read the management discussion where they took over another company.
Yet if you see that $120M leave the cash flow it had to come from somewhere, so check out the financing summary which should tell you if they borrowed the money by issuing bonds, a bank or issuing more company shares (or more likely a mixture of those). The difference is important as we turn our attention to earnings.
Beware the walking dead company, which can be identified by an interesting fact: it’s paying out more money to its shareholders than it earns. So than means it has to be paying our dividends from somewhere right, if not the earnings coming in, then it has to by default coming from the balance sheet. If that is the case you should be able to tell in rough terms if it is from selling assets, taking on more debt or issuing more shares. Regardless of how that is occurring, if it is a habit of the company to do this year over year avoid buying in. Why? The company can’t be a good business if it is constantly losing money and consuming itself in order to keep its investors quiet by keeping the dividends flowing even when it can’t afford them. A smart management team should stem the bleeding by reducing the dividend if they need to restructure in order to earn more again.
So that is brief overview of some of the key items I look at in a company’s financial reports. Recall depending what your objectives are for investing you might be looking for different things and yes there are exceptions to the above. So with that overview done I thought part III of this series, I would walk through an example. What company is on your watch list that you would like me to look at? The one with the most comments asking for it will get done.