Wednesday, February 17, 2010

How to Read Financial Statements – An Overview (Part 1) - Alpha

In this issue:
1) Principles of Reading Financial Statements
2) Types of Financial Statements and Where to Get Them
3) Financial Statements are Marketing Documents
4) Haggis is Much Worse than Spinach (Reading Recommendations)

My advice to small-time savers: “Avoid stocks.” I tell them to buy CDs or diversified bond funds from Vanguard or Pimco, such as: BND, BIV, BVV, VBMFX, VIPSX, or PTTAX. For many, buying a stock index fund is a poor idea. You need a sense of whether the stock market is over- or under-valued before you buy – the price you pay matters. Over the very long run (30 years or longer), a stock index like the S&P 500 (SPY for the fund) will likely outperform a bond fund, but there is no guarantee for this. Also most investors are mortals with shorter investment horizons and nerves of jelly, who can’t psychologically take large losses. So I suggest bond funds instead of stock funds. For the few who want to get their hands dirty and directly own stocks, bonds, or ETFs, it’s essential to: i) have a decent business sense, ii) learn how to read financial statements and value securities. Since the conversation in Risk Over Reward is about thinking about investing, I will share some of our thoughts on “How to Read Financial Statements” over a series. This series will be a starting point for curious people to teach themselves how to read financial statements.

The first letter in the series begins with principles and high-level exposure. The remaining ones will go into the dirty details of the statements themselves.

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1) Principles of Reading Financial Statements
Before jumping into the types of statements and what they mean, I offer some basic principles below.

A bird in the hand is worth two in the bush. Investors read corporate financial statements to buy securities and make money. They invest $1 today to get $2 tomorrow. More specifically, the investor Ben Graham believed stocks should return twice (2x) what investment grade bonds did to be worth the extra risk. That basic tenet is ignored in today’s “Cult of the Equities,” but it will return. To evaluate any security (bond or stock), Warren Buffett stated his formula in his Berkshire Hathaway annual letter in 2000:

Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component usually a plus, sometimes a minus, in the value equation.

Alas, though Aesop’s proposition and the third variable that is, interest rates are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it, is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities, that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Principal-agent problems stink. When you (the principal) hire someone else to work for you (the agent), the agent’s self interest may differ from yours - her actions may help her and hurt you instead of benefitting you. It’s a conflict of interest. The classic example is corporate management (RJR Nabisco is just one case). Executives often spend money on perks, like corporate jets and celebrity sponsorships, instead of paying dividends to shareholders or buying back stock. This is still a huge problem. You can buy undervalued stock in a profitable, healthy business and never make money. If investors lack control, managers eat their cake. That’s why bond investors get covenants and why shrewd stock investors get board seats – to protect themselves with control. There’s only one way to know how faithful or greedy managers are: read the financial statements. The problem is that the managers are the ones making the statements, and they pay the accounting firms to “audit” them. Perhaps the principle here is: “Trust, but verify.” You will have to watch for common accounting shenanigans.

Bounded rationality forces humility. Human beings aren’t rational much of the time. The limits of cognition, time, and energy can rob one of understanding or lead one to make poor decisions. This means some financial statements are too difficult to understand, like General Electric (GE). Others are black boxes and impossible to understand, like Citigroup (C). I generally put these in the “too difficult” pile, after spending a frustrating few hours trying to understand them. Even for simpler, “bread and butter” companies like Chipotle (CMG), items like capital expenditures can be difficult to project. Finally, as Warren Buffett points out above, many businesses are too unstable; you just can’t understand them, let alone value them. Bounded rationality forces you to stick to your circle of competence (the small circle in which you know much more about something than most people know).

A representation of reality isn’t reality. Financial statements are a representation of reality, of a company’s economic and financial health. But don’t get confused. The numbers aren’t reality. Just as pictures of the Great Pyramids can be crudely or subtly doctored in the lab, so can financial statements. Too often, people assume “facts” like numbers and numerical tables in financial statements are true. Sometimes the numbers are wrong due to fraud and mistakes. Other times, they are true in a narrow context but misleading in a broader one. Also, a snapshot at a point in time can be misleading. Many large broker-dealer banks, for example, do massive financial transactions before a quarter’s end to make their balance sheets look cleaner and healthier on the last day of the quarter (the reporting day). They undo this a few days into the new quarter and go on with their sordid, risky business. So: be skeptical.

You can’t buy breakfast with earnings. Cash flows matter more than earnings. Under the accounting rules of GAAP and IFRS, “accrual earnings” are supposed to present the economic substance of a company’s performance. Accrual earnings are useful to know but are overemphasized by Wall Street and dumber investors. Companies can manipulate earnings easily, but it’s tougher to manipulate cash flows (Enron made a valiant effort). Shrewd hedge fund investors and savvy managers care about one thing: free cash flows, that is, cash flows that can be taken out of the company to pay investors. Or as Coke’s former CEO Roberto Goizueta had stitched on a pillow: “The one with the biggest cash flow wins.”

Numbers without context are meaningless.
All the numbers in financial statements are measured in reference to something else. By themselves, numbers mean little to nothing. So a newspaper could blare that Coke earned $2 per share this quarter and Pepsi earned $2.50. Does that mean that Pepsi is “better?” Not at all. Perhaps Coke’s stock is trading at $20 but Pepsi’s stock is trading at $50, so Coke is giving a 10% earnings yield and Pepsi is giving a 5% earnings yield. Maybe Pepsi is taking on much more debt and risk to get its higher earnings, and the company could implode and wipe out all the shareholder value. Or maybe Pepsi stuffed its channels to increase current sales and profits at the expense of future ones. Or maybe all else is equal but Coke has much higher earnings growth rates and will overtake Pepsi soon. The point is that a single number means little. The significance of the number comes from the multiple possible contexts in which you examine it.

Treasuries are your measuring stick. All financial assets are measured in reference to the yield being offered by 10-year US Treasuries, what investors call the risk-free rate. Without a measuring stick, it’s impossible to know whether the earnings and cash flows a company generates, relative to assets, book value, or market value, are high or low. Some investors prefer to use 10-year German Bunds (Bundesanleihen are the government bonds of the Federal Republic of Germany). All investors compare the yields (earnings, cash flow, dividends) from corporate financial statements to those from government bonds. Bond investors do this explicitly with spread and OAS calculations. Stock investors do this with P/E capitalization rates and the discount rates in cash flow models. The latest US Treasury and German Bund rates are here:

Bond Yields and Rates from Bloomberg

2) Types of Financial Statements and Where to Get Them
The rules that govern how companies prepare and present their financial statements come from either:
i) Generally Accepted Accounting Principles (GAAP), set by an American organization, FASB, in Connecticut; or,
ii) International Financial Reporting Standards (IFRS), set by an international organization, IASB, in London. Learn more about the IFRS here.

For decades, all American companies had to follow GAAP due to SEC rules. In the last decade, many international companies have been switching to IFRS and the SEC has slowly encouraged American companies to switch to IFRS. The two standards are fairly close and will converge into one, the IFRS, by 2015.

In today’s internet driven world, you can access financial statements in two ways:

i) Directly from a corporation’s Investor Relations website: For Coke’s latest annual report, use Google with the search term “Coke Investor Relations.” It will take you here (and the tab on the left will take you to their reports):

ii) Indirectly from the SEC’s EDGAR database:
The SEC requires all companies to file a range of financial statements in its online, EDGAR database. EDGAR is a gold mine of “neutral” financial statements (just black and white “facts” – no marketing pictures, spin, and such). Any serious investor has to become familiar with it. You can find EDGAR here (you should bookmark it – it’s the place on the web I visit most often):

Searching by the company’s name or ticker symbol (KO for Coke), takes you to a place where you can directly access the filing, or filter the results by a filing type:

The SEC has numerous types of filings, which I rank by tiers based on their importance.

Tier-1: Annual and quarterly statements, prospectuses

10-K – Annual reports. The best general description of a business and its performance; verified by an independent, outside auditor.
10-Q – Quarterly reports. Not as long and descriptive as the annual and un-audited, but offered quarterly.
S-1 and/or 424 – Registration forms and prospectuses for new securities. Every time a company offers new securities it has to release one of these, and they are a treasure trove of information.

Tier-2: Other statements

DEF14A – The proxy statement - it has information on executive compensation and perks, along with other control and ownership information.
8-K – Events or changes between quarterly reports – contains material information about events between quarters. Often bond indentures and their covenants are hidden away in these reports.
144 – Proposed sale of securities. This lets you know what other securities a company is selling every quarter to the primary market.
4 – Insider trading. This contains information on insider sales and purchases.
20-F – Annual report for a foreign company. If a foreign company’s stock trades in the US as an ADR, it must file with the SEC.
6-F – Quarterly report for a foreign company.

This list isn’t exhaustive. I regularly use about 5 to 7 other reports not mentioned above, but I’d rather not discuss them as they’re less well known and I like the lack of competition. These tend to be niche reports only of concern to investment professionals, so don’t worry about them. For a full listing of all SEC reports and examples of them, see this list: SEC Filings Types

3) Financial Statements are Marketing Documents

One thing about Bloomberg and all the secondary information databases: they lull investors into thinking that what’s on the screen is correct, true, and “real.” This is where I refer people back to the principle that “A representation of reality isn’t reality.” More specifically:

carefully presented, often audited, over-lawyered,
created by a company’s management
(stocks, bonds, loans, etc., but please don’t read the fine print or footnotes).

Anytime someone is a selling you a bill of goods, my admonition is: Caveat emptor (buyer beware).

I have found that paranoid and skeptical people who verify, verify, and verify tend to be the best investors. So an attitude of skepticism is called for, as management will often know more than you do about their company and its industry. It’s a situation of information asymmetry. They know more. You’re a sucker with money. A sucker with money often ends up just a sucker.

Besides an overlay of skepticism (even for EDGAR documents), you need to remember that there are multiple users of financial statements, including:

• Lenders and bond buyers (Creditors): They don’t care about earnings per share, book values, or P/E ratios. They want to get their money back with interest; they use covenants to manipulate management. After a careful balance sheet analysis, creditors look at coverage and try to measure the risk of default and loss-given default (LGD).
• Shareholders: They care about the traditional analysis ratios and metrics. In the last few decades, shareholder primacy and the “Cult of the Equities” have led financial statements to be targeted toward shareholders (witness income statements, with EPS on the bottom, but not coverage ratios). While dividends and other payouts became démodé in the nineties and aughties (buybacks were the exception), payouts to shareholders will come back into fashion.
• Recruiters and consultants: They want consulting gigs to assess companies and industries, hire away the best managers, and generally milk the cash cow that a large corporation is.
• Managers: They are always selling others on something. They want raises from shareholders via the compensation committee (and they use consultants to justify outrageous pay). They want cheap capital from the bond markets. They want competitors and regulators to leave them alone. They want workers to be more productive and accept less salary and fewer benefits. Managers are the ones who make the marketing documents we call financial statements.
• Competitors: They want a scoop on profitable lines of business and profit margins so they can perhaps come in to compete. Managers want to conceal sensitive information, but generally err on the side of concealing information helpful to investors.
• Government Regulators: They want to make sure a company is “safe”: safe products for consumer goods, a safe balance sheet for banks and insurance companies, or safe regulatory compliance, such paying the right amount of taxes (IRS agents start with financial statements).

So financial statements tend to be long and disjointed. They are sophisticated, technical, marketing documents for multiple audiences. You shouldn’t read them like a novel, from beginning to end. Instead, focus on the sections important to you. The next letter in the series goes into details.

4) Haggis is Much Worse than Spinach (Reading Recommendations)

Now to the reading list. Warren Buffett called accounting the “spinach” for investors. No one really likes accounting, but eating it makes you better at understanding businesses and allocating capital. His analogy fails for me because I like spinach – it cooks rather well in many dishes. I would say that learning how to be a better reader of financial statements is more like eating haggis, which is Scottish oatmeal mixed with sheep's 'pluck' (heart, liver and lungs), minced with onion, suet, spices, and salt.

The following books aren’t easy, but they’re where you should turn after this series for a much fuller, self-education:

First Course - Philosophy
1) Benjamin Graham, Security Analysis (Sixth Edition – Commentary from Seth Klarman, James Grant, and Bruce Greenwald) (I recommend reading all the editions, First to Fourth, to learn how to think).
2) Leopold Bernstein, Analysis of Financial Statements
3) Warren Buffett (ed. Lawrence Cunningham), The Essays of Warren Buffett

Second Course – Technical Skills
4) Martin Fridson and Fernando Alvarez, Financial Statement Analysis
5) Charles Mulford and Eugene Comiskey, Creative Cash Flow Reporting
6) Raymond Suutari, Business Strategy and Security Analysis

Third Course – Detecting Manipulation and Fraud

7) Howard Schilit, Financial Shenanigans (2nd Edition)
8) Kathryn Staley, The Art of Short Selling
9) Joseph Wells, Fraud Casebook: Lessons from the Bad Side of Business

Fourth Course – Putting Everything Together
10) The Certified Financial Analyst (CFA) Course of Study: It’s a great starting point for accounting, statistics, and valuation. I’ve taken the course and exams and I highly recommend them.

For more recommendations, see this list: Investment Classics.

The skill of reading financial statements to understand businesses is a self-taught skill. Others can prod you in a certain direction. But it takes time, practice, skeptical thinking, perseverance, and even more practice (the ten thousandth financial statement you read will be the first you understand). Ultimately it’s up to you.

Your experienced and ignorant investor,
Copyright 2010 Risk Over Reward. All Rights Reserved

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1 comment:

  1. President Obama, Bernanke, and Jim Cramer are in a MOVIE about hedge funds called "Stock Shock." Even though the movie mostly focuses on Sirius XM stock being naked-short-sold to near bankruptcy (5 cents/share), I liked it because it exposes the dark side of Wall Street and reveals some of their secrets. DVD is everywhere but cheaper at