The first step to doing your own fundamental analysis on stocks is being able to read annual reports. In this post, I’ll show you why you need to learn how to read annual reports, as well as some tips and tricks and complete breakdowns.
Why is it Important?
If you want a fighting chance at picking individual stocks, you must know how to read annual reports. The ability to read annual reports is the bedrock foundation of fundamental analysis.
The fact that public companies are forced by law to submit annual reports, also known as 10-k’s, is the big reason why they are so crucial when you are deciding on and researching stocks. This one commonality between all of the stocks listed on any index gives you a level playing field and a chance to be able to discern winners from losers.
You must be objective with your investments. If you don’t have an objective way to measure success, how can you ever hope to find it?
For example, take the hypothetical worker at a Fortune 500 firm. That worker could possibly have contacts in the company, and access to management unlike access available to the general public. On the surface you might think this gives the worker an advantage with investments. If they can only get some inside information, you think, then they could know when to invest.
On the contrary, this is the absolute worst way to evaluate stocks. There is not a single person on this planet, not even an investing great like Warren Buffett, who has the time and the access to be able to converse with management over whether their company is a good investment. Besides that, I’m sure there isn’t a management who doesn’t think they are doing even a satisfactory job, which we know can’t be the case. Bankruptcies will continue to happen like they always have, and by definition every management can’t be doing average or better than average. So the deduction you might get from a conversation with management might be skewed.
Investors’ only chance at outperforming the stock market come in leaning more on objective rather than subjective measures.
The only reason that the numbers system works is because it is an objective system. No matter if the sun is out or if it’s raining, the number 2 will always be the number 2. It doesn’t matter if you’re having a horrible day or a great one, 21 always means 21. Numbers are the ultimate form of objectivity.
Annual reports are naturally objective, which should be music to your ears. The fact that there are GAAP audited standards means that every stock is subjected to the same qualifications. No matter how many great writers or infographers a company has on staff to flower up the annual report, the company can’t hide from the audited and consolidated numbers. Which brings me to my next point.
Learning What to Read
When I say learn how to read an annual report, I really mean that you have to learn how to find and interpret the important numbers in there. I can assure you that over 95% of an annual report is useless to you. A lot of times companies will add stuff in there that is unnecessary, with unnecessary graphs and numbers to make things look better than they are. I see it all the time.
You must learn to separate the useful wheat from the chaff. Oftentimes this is a task quite difficult for the novice beginner, and so they give up before they start.
Don’t give up. The power behind this skill set is both rare and substantial. Combine it with a great strategy and you can make some serious money for yourself and your family.
The first thing you’ll notice about an annual report is that it’s often over 100 pages long. The meaty part that you want to concentrate on are the “Consolidated Financial Statements”, usually broken up into:
1. Consolidated Statement of Income
2. Consolidated Balance Sheet
3. Consolidated Statement of Cash Flow
The numbers in these sections are the only ones that matter. Numbers that you pull from any other part of the annual report are not guaranteed to be audited, in fact you can probably guess that they are likely prettied up by some accountant engineering.
A mistake I see investors make is that the gloss over the importance of consolidated numbers, and just rely on financial website quotes instead. The problems can arise twofold.
Firstly, think about how many stocks there are (hint: in the thousands) and how much information must be processed by any one financial website. When you are getting your data from a secondhand source instead of the primary source, mistakes can and do happen. I see it more often than you’d think. Mistakes in the original source, the annual report, are much rarer because again they are audited and submitted to the SEC.
Secondly, numbers from a financial website can be extremely misleading. A company will spit out ratios, but oftentimes there’s no way of knowing how they calculated them. Ratios, especially complicated financial ratios, can be calculated a broad variety of ways. A financial website might have equations and calculations that are optimized for the short term, while you are looking for long term. This can also skewer your results. Many financial websites rely on quarterly reports, which are much more frequently adjusted than annual reports. When risking your hard earned money, why wouldn’t you want only the most secure source of information?
By now you should understand the importance of what I’m trying to teach. Here’s how I do it.
How to Read Annual Reports
Go to sec.gov. Click on the blue button on the right that says “Search EDGAR for Company Filings”. In the Fast Search section type in the ticker of your stock and click search.
Under “Filing Type:”, type 10-k and hit enter. Now you’ll see a list of every submitted annual report since 1994. Click the documents tab.
Now you’ll see a list with various documents. Most of the time the consolidated financial statements will be in “10-K.”Click on the .htm file for this description. Then hit “Ctrl+F” on your keyboard to open up the search function. In the search bar type “Consolidated balance sheets”. Hit “enter” and scroll through until you reach the heading of the section entitled “Consolidated Balance Sheets” (if you can’t find it keep reading below).
In the case where the consolidated financial statements aren’t there, they are in “EXHIBIT 13” or “EXHIBIT 14”. Don’t ask me why, I don’t know. So go back to the list of .htm documents and repeat the process in “EXHIBIT 13” or “EXHIBIT 14”.
Once you’ve done that, you’ve just learned how to quickly find the most important section of an annual report. That’s the good news. Bad news is that you are just getting started, and now you have a sea of numbers to sift through and derive meaning from. Luckily for you, I’ve covered every single number in detail, as well as a simplified version telling you just what you need to know.
Click the links below to read through the guides I’ve created, I hope they serve you well.
1. Simple Balance Sheet Analysis
2. Line-by-Line Balance Sheet Breakdown
3. Simple Income Statement Analysis
4. Line-by-Line Income Statement Breakdown
5. Simple Cash Flow Statement Analysis
6. Line-by-Line Cash Flow Statement Breakdown
**How to Read Annual Reports for Beginners**
**All Rights Reserved. Investing for Beginners 2014**