The great question in financial research of today reads, “Is the market efficient?” That translates into, “Is it worth doing research on companies, or does the prices of securities like stocks already include the effects of published information?” Many experts believe that we have enough computers tracking the simple ups and downs of stocks that any patterns of movement have been exploited. But the financial statements issued by companies are daunting to the average day trader, and evidence suggests that reading them can give you an investing edge.
First know, however, that you absolutely must look at the industry standards. If a car maker is has a debt to equity ratio of 9:1, meaning that it is funded 90% with debt, you should run from that stock. A bank financed that way, however, is not making good use of its resources and should borrow more. The industries are very different, and so you should have very different requirements for the financial statements. The standards can be found at various websites.
It’s not enough to look at the numbers. You need to dig into the notes as well. It’s not as hard as it looks. Most of the notes are cut and paste from standard disclosures. After a few reads your brain will scan the normal notes and the changes will start to jump out at you.
These are some solid red flags:
Almost all stock options are given to employees, usually high management, as part of their compensation. They are normal, but increasing numbers will hurt you. For example, if a company offers a stock option to buy at $10 a share, and the stock sells for $50, then the owner of the option gets $40 from the existing stockholders as a bonus. In theory the options are set at or just above the stock price so that the employees have an incentive to increase the share price. It doesn’t always work that way.
If salary’s jump by 50% and the mangers are explaining why they laid hundreds of people off, something is amiss.
It’s one of those strange aspects of accounting. Companies are required to list all lawsuits that, if they lost, would significantly impact their financial statements. Ones that they might win are irrelevant. However, since you really can’t estimate the risk or the cost well enough to disclose the expected outcome of a lawsuit, the investor has no idea how big that impact could be. If it’s a patent issue consider moving on.
The Sale of Treasury Stock:
This is stock that the company has bought back or never issued. It is sold to raise money. Why is the company raising money? If you don’t know, they may not want you to hear it.
Depreciation is the cost of equipment spread over its useful life. If depreciation is steadily going down over the years, or is much lower than the rest of the industry, and there aren’t many leases somewhere in the notes, the company may not be replacing its assets as needed.
Drop in cash or prepaid expenses or inventory:
You can check this quickly with the “quick” or “cash” ratio. If it is too low the company can actually default on debt, forcing it to file an unnecessary bankruptcy. “Cash Equivalents” is the same as cash.
Purchasing another company:
There had better be a very, very good reason for it. Usually the parent company’s stock takes a hit. Look for synergy, like a winery purchasing grape farms.
Other signs aren’t nearly so bad
Look for the term LIFO in the notes. It will have the actual value of the inventory inside. LIFO, or last in first out, is used for tax purposes and doesn’t really mean that they have 100 year old candy in boxes (that’s what auditors are supposed to look for). If the LIFO inventory has dropped considerably, the earnings may be inflated a bit. Use the FIFO equivalent to compare against the industry standards.
Financial statements are issued from an incredibly complex set of rules, and companies simply cannot predict the changes. If the cash is flowing well but the earnings dropped badly due to an “accounting correction”, you might be looking at an undervalued company.
Audits by an Unknown Auditor:
Google the accounting firm and make sure they have at least a dozen partners. Mid-sized accounting firms often do a better job of looking at the company’s inner workings than famous nationwide firms. This may be a good sign that management is taking its job seriously.