All value investors should know how to read a 10-K statement. This is part two of a short guide for how to do so. You can read part one here.
In the previous article, I discussed some of the questions that I believe investors should be asking themselves when reading through the initial business summary presented by management in the 10-K. Now, let’s move on to how to read management’s notes on recent performance and the consolidated financial statements.
What is management telling you?
Usually, management will highlight the metrics that it deems to be important before you get to the actual financial statements.
These are interesting because they tell you a lot about what a company thinks is important, and also what it wants to emphasise. Conversely, seeing what is not included is a good indication of what management is trying to bury.
For instance, it has been common practice over the last decade for rapidly growing (but unprofitable) tech companies to trumpet revenue growth and de-emphasise earnings. This isn’t to say that just because an important metric isn’t highlighted by management that there is something wrong with the business, but it is certainly something to keep an eye on.
You should also look for an explanation of any non-GAAP accounting in the financial statements. There needs to be a good reason for the inclusion of these figures, and if management is not able to provide that reason, then that could also be a red flag, especially if there is a significant difference between non-GAAP and GAAP earnings.
Financial statements
Once you understand the business and have looked at management's comments, you are finally ready to read the financial statements.
Here are a few of my general tips and techniques for quickly gleaning what you need to know from the balance sheet, income statement and statement of cash flows.
Firstly, look for any figures that change significantly from year to year. By this point, you should know what the business does, and what its management considers to be important. Are they meeting their own goals? Are they falling short in other areas? Was this disclosed, or did you figure it out for yourself from the financial statements? If yes, what does that tell you about the executives and board?
Finally, I will share one of the best pieces of financial advice that I ever received, which is to pay attention to the granting of stock options and the level of stock repurchase. These two things, taken together, can tell you an awful lot about the company. It can help you differentiate self-serving management that is trying to enrich itself at the expense of shareholders from genuinely long-term oriented management whose incentives are well-aligned with those of ordinary shareholders.
Look at the prices at which stock was repurchased as well. A management that buys back its own shares at cheap valuations is being smart. A management team that buys back shares at inflated valuations to make their own stock options more valuable is being self-serving. In the long term, quality of management is the factor that really differentiates good investments from poor ones, in my opinion.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: How to Read a 10-K, Part 1
- Howard Marks: The Problem With Forecasters
- Why Peter Lynch Loves Volatility
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