Some investors follow the advice of their stockbrokers when choosing stocks. Others use investing publications or mathematical formulas to make their choices. A few simply throw darts at the stock pages of their local newspaper.
What’s a novice investor to do?
For starters, read the annual reports of companies in which you are considering investing.
Annual reports are valuable because they tell you what a company does, how it does what it does and how it makes money doing what it does. That gives you a pretty good idea about whether you want to invest in the company.
But beware. An annual report is like an infomercial: a glossy, magazine-like publication that shows the company in its most positive light. Sometimes information is buried in a footnote, so it’s important to study the fine print as well as the photos of smiling employees.
The most basic mission of the annual report is to tell shareholders what happened last year.
The chairman’s letter to shareholders is a good place to start. The letter typically is found on the first few pages of the report and is signed by the chairman, chief executive officer or president.
“Investors should read (the letter) not only for the positive things that have happened but for the challenges or problems that have happened,” said Katherine Philipp, a spokeswoman for the Securities and Exchange Commission’s office of investor education and assistance. The SEC enforces federal securities law, which regulates the information companies include in their annual reports.
“A forthright CEO will address the negative as well as the positive,” Philipp said.
Because of the new “safe harbor” law that offers companies some protection from shareholder lawsuits, these letters are looking ahead more and more.
Progress reports on each business division usually follow the chairman’s letter. This is where you’ll find many of the photos and charts.
Next, Bob Littman, a director of regional accounting firm Saltz, Shamis & Goldfarb, looks at the section often called “Management’s Discussion and Analysis.”
This section explains sales, income and cost changes in the most recent year and in the two preceding years. This section also explains one-time events, such as the purchase or sale of a business or a change in accounting practices.
“I look at what management is forecasting, where they’re going in the market,” Littman said. “Then, maybe, I’ll look at numbers.”
The numbers generally take three forms: income statement, balance sheet and cash-flow statement.
The income statement starts with sales or revenues and ends with the bottom line–profit– which sometimes is called “net earnings” or “net income.” In between are all the costs.
Is net income a positive number? If so, your company is making money. Is that number higher this year than last? If so, your company is growing.
Of course, if net income is negative, your company lost money. The management discussion and following footnotes should tell you why.
The balance sheet is like a snapshot of your company’s assets and liabilities. You’ll notice that the assets are equal to–or balance–the liabilities and shareholders’ equity.
The balance sheet makes sense only if you compare it with past years.
For instance, one of the lines under assets likely is “inventory.” Is inventory rising or falling? Slowing sales can cause a rise in inventory. And inventory is expensive. Look for an explanation in the management discussion or footnotes.
The cash-flow statement tells you how your company collected and spent its money. If the final cash-flow figure is positive, that’s the amount of cash the company generated last year. If it’s negative, that’s how much money the company used last year.
Your company hires an independent auditor to check the numbers in its annual report. The auditor, usually a large accounting firm, writes an opinion about the numbers. If an opinion is “qualified” or limited, you know the auditor doesn’t trust management’s numbers.
Warning: The auditor does not verify the accuracy of the numbers, only that they were gathered in an acceptable way and appear to reflect accurately the financial condition of the company.
The final and most overlooked part of the annual report is the footnote section. This is where all the dizzying figures are tossed around in dense legal language.
What’s in a footnote? What your company owes to its creditors and when. What shape its pension plan is in. How your company counts its inventory.
“Specifically, I look for the `contingency’ footnote,” said University of Akron accounting professor Penny Marquette. “That will tell you whether they’re being sued. Or if there’s anything hanging around that could pop up and be a disaster. I skim all the other notes.”
LEARNING THE LINGO
– Net sales–Sales minus returns and discounts. Some businesses call this revenue.
– Net income–Net sales minus all expenses. This is the proverbial bottom line, also called profit or earnings.
– Earnings per share–Profit (or loss) divided by the number of shares of stock in circulation, called outstanding shares. This number also helps you figure out the value of your investment.
– Price/earnings ratio–Stock price divided by yearly earnings per share. The resulting ratio tells you how expensive your investment is relative to its earning power. Generally, the higher the ratio, the more expensive the stock.
– Shareholders’ equity–Assets minus liabilities. Also called net worth.
– Book value–Assets minus liabilities, divided by the number of outstanding shares. This tells you what your stock is worth. A rising book value is good for an existing investor. Potential investors will look for low book values that have the potential to rise.
– Working capital–Current assets minus current liabilities. Current assets are things like cash or accounts receivable–assets that can quickly be converted to cash. Current liabilities are debts the company must pay within the year.
– Dividend–A percentage of profits paid to shareholders each quarter or year. Your company should be paying shareholders between 25 and 50 percent of earnings. A higher percentage than that means your company is not earning enough to meet its obligations and may soon lower its dividend.
