If you want to learn more about a company or invest in a company, you can find a plethora of information on the company’s annual report, otherwise known as a 10-K. The 10-K offers an in-depth look at a public company’s financials, the risks it faces, and operating results for the previous year.
Warren Buffett is famous for reading 500 pages a day, and the majority of those are 10-Ks. So if you want to invest like Buffett, you must do like Buffett.
With the most recent earnings season upon us, as well as the starting of the release of annual reports, I thought this would be the perfect time to explore the annual reports or 10-Ks more in-depth.
What we will cover today:
- What is a 10-K?
- What Sections are In a 10-K?
- Where do We Find a 10-K?
- How Does Warren Buffett Read a 10-K?
I’ve also done seperate guides for each of the 3 financial statements, which you can peruse here:
- Simple Income Statement Structure Breakdown (by Each Component)
- Simple Balance Sheet Structure Breakdown (by Each Component)
- Basic Cash Flow Statement Breakdown (by Each Component)
Are these reports always the most exciting to read, probably not, but there are ways to make them more enjoyable, in addition to more revealing. Think of reading a 10-K like a puzzle; it is our job to put all the pieces together to determine whether it is a wonderful company or not.
One of the practices that I picked up from Andrew was to create a spreadsheet and notate when the date each company that I own issues their annual reports so I can stay up to date on my investments.
There are many sections to the 10-K, some of which contain boilerplate language, which means that it is legal language; they must include covering any possible legal actions. As you gain more familiarity with 10-Ks, you will have the ability to skim over these sections and spend more time on the relevant sections.
Think of learning to read a 10-K like any other aspect of investing, another skill to learn that will come with practice, the more you do, the better you will get at them. The bonus is that once you get comfortable with a company, the easier it will be to read each successive year.
Ok, let’s get to it, shall we?
What is the 10-K?
From the SEC.gov:
If you want to follow or invest in a U.S. public company, you can find a wealth of information in the company’s annual report on Form 10-K. Among other things, the 10-K offers a detailed picture of a company’s business, the risks it faces, and the operating and financial results for the fiscal year. Company management also discusses its perspective on the business results and what is driving them.
I think that sums it up pretty well; remember that some companies will issue two reports, the annual report (usually posted online), and the 10-K (filed with the SEC). The 10-K is required and is audited, so one would think there is a measure of truthfulness to it.
By the way, sec.gov is a fantastic resource, not only for financial reports, but they also have a great learning section.
The annual report is a marketing opportunity; it only highlights the positive going on with the company. It usually has gloss pictures, nice graphs and charts, and lots of flowery language. A take I heard recently from a mentor, CEOs are salesmen, take what they say with a grain of salt.
Reading SEC filings like the 10-K is the path to learning what you need to learn, finding the nuggets in the 10-K can lead to some wonderful investments.
The trick is knowing where to look, let’s dive into the different sections of a 10-K.
What are the different sections of the 10-K?
There are two parts to each 10-K; we will take a brief look at each section. I am going to focus on the more important sections; for a deeper look, please visit sec.gov.
Item 1: Business – this section is a description of the business, and it includes its main products and services, other companies it owns, and what markets it operates in, such as China, Europe, or Ohio. Other items in the section might include:
- Info about recent events
- Regulations, i.e., banks
- Labor issues, i.e., labor unions or wage increases
- Operating costs unusual to them
- Seasonal factors, i.e., agriculture
Section 1 is “THE” section to begin with to understand the company and what they do.
Item 1A: Risk Factors – Here, we will find the most relevant risks that apply to the company. The good news is that most companies will list risks in order of importance. The not so good news, the companies usually list only risks, not how they address them. Some of these risks will apply to the whole industry or economy. Some will only apply to the company itself. There will be quite a bit of “boilerplate” language in this section, so you might experience a bit of eye glossing over in the section, but there is some valuable information here. The trick is learning to skim this section looking for info specific to the company.
Item 1B: Unresolved Staff Comments: In this section, you will find comments from the SEC that pertains to comments from previous reports that are unresolved over an extended period. Again more boilerplate language, but keep an eye out.
Item 2: Properties – Here, you will find information about properties such as plants, mines, office building, real estate it owns, or any other physical properties it owns.
Item 3: Legal Proceedings – Any sort of legal issue the company is dealing with is outlined here. Think significant issues like being sued for asbestos in older buildings, or mistakes in manufacturing a car.
Item 4: This section will typically be empty, it is left open for the SEC for future rules, if needed. Yah, an easy section to read.
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities – in this section, we will find information about the number of the holder of shares, dividends, repurchases, and the company’s equity securities.
Item 6: Selected Financial Data – here, the company will extract financial information they feel is relevant over the last five years. Typically, this is a snapshot of the financial situation of the company, with a mashup of information from all three sections of the financial reports.
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations – The number one section to read, if you read nothing else. This section gives us a perspective of the management and their thoughts on the performance of the company. Also known as the MD&A, it allows the company to tell its story in its own words. We will find:
- Company operations and financial results.
- Info about the company liquidity and capital resources
- Trends or uncertainties that could impact the business
- Managements discussion of the risks the company faces and how it plans to address them.
- Address changes in the results of the company
- Discussions about accounting judgments and
- These assessments can have a huge impact on the financials, so they bear some scrutiny.
Item 7A: Quantitative and Qualitative Disclosures about Market Risk – This section requires commentary on the company’s exposure to interest rate risk, foreign currency rate risk, commodity price exposure, or equity pricing risk. Here the company will discuss how it handles any of the above risks.
Item 8: Financial Statements and Supplementary Data – The meat and potatoes here, in this section, you will find all the required financial data a company is required to provide. Included are the audited forms:
- Income Statement ( Statement of Earnings, or Statement of Operations)
- Balance Sheet
- Statement of Cash Flows
- Statement of Stockholders Equity
This section will include any pertinent notes concerning the financial statements. All U.S. companies are required to present their audited financial documents according to the accounting standards known as GAAP, known as Generally Accepted Accounting Principals. GAAP is important to note because these reports are audited by outside auditors to ensure fairness in reporting.
Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure – here, you will find any disagreements with the accountants, or if there is a change in accounting firms running the audits. Many investors consider this a big red flag.
Item 10: Directors, Executive Officers, and Corporate Governance – We will find a listing of the directors and executive officers, as well as their experience and backgrounds. Also listed are items such as code of ethics, and committees of the board of directors.
Item 11: Executive Compensation – Want to know how much the CEO of the company makes? Here you will find their compensation as well as the other officers of the company.
That is a brief outline of the different sections of the 10-K, there are a few more sections that I didn’t mention, but they are more legal jargon or requirements that I feel don’t offer much information relevant to finding a great investment.
So let’s move on to what we are all waiting for, how to read an actual 10-K.
10-K Analysis Example
For our example walk-thru of a 10-K, I would like to use Hormel (HRL) as our guinea pig, if you will.
There are several ways to do this; the first part is to skim through the sections and pick out relevant information as you go through the sections. Some people like to print off the physical copy and mark it up with notes as they work through them. Others like to take notes, via either Word or Google or whatever note-taking app you prefer. I like to use Google because I can sync it to my phone and read my notes wherever I am.
Whichever way you choose, taking notes to help you remember is crucial because unless you have a photographic memory, there is no way it will all stick.
What we are going to do is walk through the document and pick out some relevant information, and then we will do a deep dive into the financial section.
The first section we are going to read is Section 1. As you recall, this section will outline what the company does, as Buffett likes to say this is where we can find whether the company will sit within our circle of competence.
In the first part of the business description, Hormel outlines what it is they do and where they do it. They also list some important acquisitions and sales of different segments over the years. I have highlighted items that I would add to my notes. Most time, I would simply copy and paste right into my document for ease.
The continuation of the business section highlights the different raw materials that the company reports business results from; this is very common and something worth noting. Next, Hormel discusses some of their products and sourcing, plus pricing concerns and relevant contract pricing controls.
The next section outlines some important information about their customers and the impact they have on Hormel’s business. They also list their closest competitors, plus the number of employees on the payroll.
The next section to look at is the listing of all the corporate officers, which lists their positions, various positions held with the company, and their ages. Not all information is relevant, but I like to see who the CEO is and his age, for future reference.
After that is section 1A Risk Factors, in this section, we will find a listing of all the potential risks possible for the company to experience. Most of this section is standard, legal information; there isn’t a lot of information listed about how the company will deal with any of these possible risks.
Most of the risks associated with Hormel are going to be food-related, which makes sense.
This section I like to skim through and see if anything catches my eye to investigate further later on in the 10-K.
The next sections 1B, 2, 3, and 4 contain information that is not relevant to our discussion here if there were legal concerns they would pop up in section 3.
Section 5 contains information on the performance of the stock over the last five years. It also contains information regarding dividend payments. Other than the conversation about dividends, not much of note here.
Section 6 provides a snapshot of the financial condition of Hormel. Items included here are net sales, earnings, EBIT, return on invested capital. Also included are items from the balance sheet such as assets, liabilities, shareholder equity. Finally, you will see info from the cash flow statement such as cap-ex, dividends paid, share repurchases. All of this feeds into a calculation of earnings per share and more ratios for review.
The cool thing about this section is the five-year look at the financials, which helps give us a longer-term idea of financial performance.
Section 7 is where the heavy lifting in regards to reading the 10-K happens. In this section, we will discover management’s thoughts about the business, such as growth, reasons for disruptions and how they plan to work through those, and analysis of the financial performance.
I will walk you through this section and show some highlights of things I think might be pertinent to a study of Hormel.
You are all smart people, so I am not going to point out every single detail, but each highlighted section has some nuggets that would bear reading to give you an idea of the company’s past performance and future directions.
Here we are going to see a breakdown of each segment that Hormel reports; as we get farther into the 10-K, you will see a deeper breakdown of each segment.
Here we will see the breakdown of the net sales by segment, as well as notes explaining the difference from the current year to the past year. Notice that refrigerated foods were by far the largest segment of Hormel’s business and, therefore, will bear more investigation to understand that segment and its performance.
The next section outlines some of the costs associated with net sales. I love to read the little notes below the charts as they help explain the reasons for the increases or decreases, and they give better insight into the company’s operations.
Not all the tidbits you are going to glean are vital, but they help give you a better understanding of the company. And Hormel, for the most part, is transparent about their operations and is easy to understand, at least for me.
Who likes taxes? Nobody, said everybody! But they do impact the profitability of any business, so it is important to understand them and how they are adjusted, if ever.
The next section outlining more detail about each segment of the business is a great place to learn more about each segment of the business. Most 10-Ks, if they are well written, will outline each segment in detail to give you a better insight into the operations of the company.
If they are vague here, stop reading and move onto another company! If a company is attempting to hide things from you about their operations, why would we want to invest in them?
The above pictures give you a great sense of the segments of the business, as well as their results and explanations of performance. They also list expectations for the coming year, which are incredibly helpful.
One thing I like to do regarding expectations is to highlight those in my notes and then to refer back to them. How a company reaches its expectations is a great way to gauge management, both on performance and integrity.
Hormel next goes in-depth over the prior years’ results, in this case, 2017 and 2018. I don’t necessarily notate this, but I will skim over to see if any irregularities jump out. Much of this information you can find in previous 10-Ks, or on other websites such as gurufocus.com or quikfs.net.
The next section I highlighted indicates the uses of the cash that Hormel has generated from operations. Items such as share repurchases, dividends, and other cash items will be listed here. We can find these items listed in the financials, but it is good to get a look at them here and understand management’s reasoning for the use of cash.
Understanding the critical accounting policies is a great place to ensure that accounting fraud is not taking place; in the past, some companies have fudged how and when they acknowledge revenue.
This section does contain some legaleeze, but you can skim through to the important parts; you don’t need to read this section every time, but it is good to be familiar with how the company recognizes certain accounting procedures.
Here we will find a more definitive discussion on some of the possible risks the company may face. Very important to read through this section and understand the risks.
The next section up contains the financial reports for Hormel. All four required statements are in section 8.
What I like to do is skim this section and look for any numbers that jump out as anomalies; also, I like to look and see any trends such as an increase in revenues, a decrease in costs, tax rates, and so on.
I briefly look through all four statements before I start analyzing the financials. For this section, I am going to share with you a checklist and a spreadsheet that I learned from Professor Damodaran.
Both of these items will help you look through the financial statements for the info we will need to do a valuation of Hormel, either with a discounted cash flow or any other method of valuation you prefer.
Each statement will have multiple years of data for you to observe, the balance sheet will list two years. And the income statement and cash flow statements will list three years. Starting here is a great point to observe any trends you can pick up.
But I feel that those snapshots are a bit too short for my liking, the sample size is too short. I suggest for ease to use a site like quickfs.net to see over a longer time horizon to see bigger trends.
Ok, let us get to it and start to gather a little info.
Let’s start with the key questions.
Chart courtesy of Aswath Damodaran
Ok, now that we have the questions, let’s look up some data. I am going to set up a chart based on these questions for you to use in the future analysis of 10-Ks.
Based on all the above numbers, we can calculate all the ratios we are looking for in the chart above. These are all the same metrics that we use to value a company. We are not going to discuss those metrics in-depth here; those will be subjects for another post.
I will include the above chart as a blank so you can use it for future 10-K analysis.
The link to the article that Professor Damodaran uses to discuss his thoughts on reading through a 10-K is here.
The next major section to look over in the 10-K is the Notes to Consolidated Financial Statements.
These footnotes refer to additional information that the company puts out to help explain the financial situation of the company. It can be a place to explain any inconsistencies or help provide more insight. Many investors spend a lot of time reading the notes, as they feel they are very insightful.
Here is a list of common notes to the financial statements.
- Notes that advise on significant accounting policies
- Notes about depreciating assets
- Notes about valuing inventory
- Notes that disclose subsequent events
- Notes that explain intangibles
- Notes that consolidate financial statements
- Notes that spell out employee benefits
- Notes that reveal contingencies
- Notes about reporting debt
Let’s look at a few notes from Hormel to get a flavor for how they work.
Both of these notes illustrate the kind of information you can derive from this section. Every company will list different information they think is relevant to us, the shareholder.
I encourage you to take the time to go through the notes as there will be information that can help you determine a great investment or not.
And that takes us through the 10-K, you did it! You should be proud, and I hope you discovered that it isn’t that hard or incredibly complicated to work through them.
How Warren Buffett Reads SEC Filings and Financial Statements
Buffett has repeatedly said that he reads over 500 pages a day, many of them 10-Ks. He was asked at a shareholder meeting in 1993 how he reads the reports, and this was his answer:
“First, we read a lot of them. It’s very helpful to read a lot of annual reports and trade publications to get a better fix on certain businesses. A good many I just skim. But if I’m really interested in a company, I probably read every word – although some of the general descriptions lose me a little bit. But we start at the front and read to the back if we’re really interested in it.
And we will be interested not only in any business that we own or are thinking of owning, but we’ll be interested in reading their competitors’. I get the Bic annual report. I get the Warner Lambert annual report to read about Schick. I get the PepsiCo annual report. I get the Cott Beverage report. Cott Beverage makes more of the generic colas than anybody – at least in this hemisphere.
I want to know what competitors are doing and talking about, what results they are getting and what strategies seem logical to them. So I spend a lot of time reading annual reports.”
The big tidbit I took away from this article was the discussion about investigating the competition, brilliant!
Focusing on competition makes perfect sense because one of Buffett’s key ingredients to success is finding company’s that have a huge competitive advantage over their competitors. And reading the financials of other company’s can help give you that understanding.
The other key he looks for is how does management deal with problems. Reading the annual report from the CEO is one of the most important documents included in the financials. Because Buffett places such a high premium on honest, straightforward, transparent, and shareholder-friendly management, he likes to see how management thinks and behaves, especially during times of crisis.
“I’d like to have a report that would be identical to what if I owned half of a company but was away for a year but had a partner who owned the other half. When I came back, that he would tell me what had taken place during the past year and what he foresaw coming up. If we read a bunch of public relations gobbledygook, and we see lots of pictures and no facts, it has some effect on our attitude toward the business. We want to understand the business better when we get through the annual report than when we picked it up.”
Another thought he had regarding management.
“Almost every business has problems … A lot of companies, for example, have investor relations people, and they’re dying to pump out what they think is good news all the time … we try to stay away from businesses like that.“
As Charlie Munger says, they spend a lot of time trying to find a reason to not invest in the company, and their research is what helps them make that decision.
Reading SEC filings like the 10-K is an incredibly important process that you must do to become a better investor. Besides the numbers, there is a lot of information you can gather from these documents.
Like Munger and Buffett say, learning as much as you can about each business you buy is critical, not just about the numbers, but about the people running the company as well.
There is no shame in declaring that a company is too hard to understand, either because the business model is too complicated or the financials are very disorganized and not very clear. It is better to put the 10-K from a company like that instead of forging ahead and buying the company.
It doesn’t mean that you can’t learn about a business you are truly interested in, such as banks for me. Finding businesses that fall in our circle of competence can be difficult, but sticking to that circle can help prevent losing a fortune.
Reading the 10-Ks is instrumental in becoming a better investor, they can appear daunting, but I think we have seen that because they have become data dumps lately. We can filter through the chaff to find the wheat.
Remember that practice makes perfect, and reading 10-Ks requires practice, like performing a discounted cash flow calculation. The more you do them, the better you will become at reading a 10-K.
An important part of understanding a company through reading its annual report is also knowing what stage of its life cycle it is in, and how the company compares to its competitors. Some ideas to achieve this understanding can be found in these articles:
As always, I hope you enjoyed this article, and you found something of value for your investing journey. Reading SEC filings like the 10-K can appear daunting, but if you have a plan and follow that roadmap, you can do this!
If you have any further questions or there is anything else I can do to be of assistance, please let me know.
Updated 6-1-21 — Dave Ahern and Andrew Sather