Analysing Annual Reports

[robertbanking]

Hello you wonderful and intelligent individuals, i do hope you are doing well and Happy New Year, i hope this year is a good one for you.

I am trying to improve my due diligence process when reviewing stocks, i appreciate everyone will have different protocols. I please kindly wondered when you are reviewing an Annual Report of a company what do you look for to increase the chance of business success please? For instance does the business have competitive advantages etc. Lastly, can i kindly ask is there any other important parts of due diligence to look at which might be very important please? For instance large institutional ownership etc. I would be forever grateful if anyone kindly had chance to get back to me please, it would mean the world to me.

Thank you so much for your time and i do wish you a wonderful day ahead and thanks very much for reading my post.

 

[Knobby22]

Hello you wonderful and intelligent individuals, i do hope you are doing well and Happy New Year, i hope this year is a good one for you.

I am trying to improve my due diligence process when reviewing stocks, i appreciate everyone will have different protocols. I please kindly wondered when you are reviewing an Annual Report of a company what do you look for to increase the chance of business success please? For instance does the business have competitive advantages etc. Lastly, can i kindly ask is there any other important parts of due diligence to look at which might be very important please? For instance large institutional ownership etc. I would be forever grateful if anyone kindly had chance to get back to me please, it would mean the world to me.

Thank you so much for your time and i do wish you a wonderful day ahead and thanks very much for reading my post.

It depends on the business, insurance is very different to banking which is different to pharma, mining and retail.

Eps, earnings per share, highly important, P/E ratio, profit statement especially one off items and do they regularly occur? Ownership, good owners make a big difference e.g. Twiggy Forest, Gerry Harvey, Elon Musk. Cash flow, does the business need more cash to expand? Does the cash flow suit the business e.g. if it is a small mining company and lots of the money goes to staff then there is something wrong. If the company is expanding a raising might be required, if it is a biotech start up and the cash flow is such that the company will run out of it in 3 years then be careful.
Liabilities, short term, long term, too much debt greatly increases the risk.

There are books on this. I did a corporate finance subject when I did my MBA that taught me a lot.

 

[Dona Ferentes]

Best way to read an Annual Report is to start at the last page and work toward the front. Footnotes become important, and the spin less so.

 

[divs4ever]

somewhere on the internet is a Marcus Padley opinion piece on Annual Reports ( and presentations )

@Dona Ferentes has a good tip ( that i never thought of , thanks for that )​

but Marcus in his opinion piece warns of pretty ( glossy ) pictures that have no real relevance to the business ( as a quick red flag ), he suggests it is to soften you up for some bad news .

another red flag ( for me ) is long gushing CV's of directors ( the balance sheet should be doing the talking )

now personally i start with an opinion on the economy ( local AND international ) and a rough idea of the relevant sector easy for a report to look good when there are tailwinds everywhere , in troubled sectors the cleanest shirt in the laundry basket MIGHT be very cheap , and even cheaper after several have read the report ( this could be time time the computer algos are your friend, because they rely on trigger-words )

remember if you are trying to buy cheap the report will be at least conservative ( cautious )

words are like two-edged swords , words like 'restructure ' , sometimes means they have taken the wrong path , OR they really need to cut costs and raise productivity ( in theory good news , but usually requires time and money )

time and experience in reading reports AND watching the companies is a big help , some nearly always spread hope and positivism , ( and the worry of a capital raise soon ) while others tend to be cautious and under-promise ( even after record results )

ALSO take note of what currency they report in ( a miner reporting in Australian Dollars is probably doing much better than one reporting in $US or even euros )

cheers

 

[Value Collector]

Hello you wonderful and intelligent individuals, i do hope you are doing well and Happy New Year, i hope this year is a good one for you.

I am trying to improve my due diligence process when reviewing stocks, i appreciate everyone will have different protocols. I please kindly wondered when you are reviewing an Annual Report of a company what do you look for to increase the chance of business success please? For instance does the business have competitive advantages etc. Lastly, can i kindly ask is there any other important parts of due diligence to look at which might be very important please? For instance large institutional ownership etc. I would be forever grateful if anyone kindly had chance to get back to me please, it would mean the world to me.

Thank you so much for your time and i do wish you a wonderful day ahead and thanks very much for reading my post.

Whole books have been written on this topic, but in short the two factors you are trying to assess is Quality and Quantity.

Eg.

1. How good is this business I am considering buying.

2. How much of it will I get per share.

Once you get your head around those two questions then you need to decide whether the current share price is rational based on the quality and quantity you get.

——————————

To answer question 1, you have to be able to understand the business and have an accurate model of it in your head about its pros and cons and risks etc. there are also clues to it quality in its financial statements where you can calculate its return of equity, return on capital, debt levels etc.

To answer question 2 you look towards its balance sheet, and divide the total equity by the number of outstanding shares, (if large amounts of options are outstanding against it you factor these in too). This will give you an idea of how much of the company you are getting.

Ben Graham used to say you should by your shares like you buy your groceries, not like you buy your perfume.

With perfume you are happy to over pay for fashion, but with shares it should be like buying potatoes, eg how good are the potatoes and many kilos does the bag contain. Quality and quantity.

 

[So_Cynical]

One thing to look out for is an annual report that starts of with how great last years safety performance was, generally means there is no real good news.

 

[Value Collector]

This video explains some concepts of value investing and analysis of financial statements.

Using similar analysis to what is described in this video I have found some wonderful opportunities.

 

[divs4ever]

One thing to look out for is an annual report that starts of with how great last years safety performance was, generally means there is no real good news.

WOW !

maybe i should change my user name to Cynical_Two

( i often think that but wasn't game to post it )

 

[Value Collector]

It depends on the business, insurance is very different to banking which is different to pharma, mining and retail.

Eps, earnings per share, highly important, P/E ratio, profit statement especially one off items and do they regularly occur? Ownership, good owners make a big difference e.g. Twiggy Forest, Gerry Harvey, Elon Musk. Cash flow, does the business need more cash to expand? Does the cash flow suit the business e.g. if it is a small mining company and lots of the money goes to staff then there is something wrong. If the company is expanding a raising might be required, if it is a biotech start up and the cash flow is such that the company will run out of it in 3 years then be careful.
Liabilities, short term, long term, too much debt greatly increases the risk.

There are books on this. I did a corporate finance subject when I did my MBA that taught me a lot.

EPS and P/E are important, but without also knowing the Return on equity (and the likely return on retained equity and their dividend payout policy) it’s hard to know what the correct P/E should be.

Imagine you have two companies ( A & B) both earn $1 EPS, Both trade at a P/E of 10 ($10 / share) and both pay a dividend of $0.50 / share.

A. Has a Return on equity of 20%

B. Has a return on equity of 5%

This ROE difference makes a huge difference in their valuation, even though their P/E and dividends are the same.

At the end of the year, once they have paid out $0.50 dividend and retained the other $0.50, company A. Puts that $0.50 to work at 20% increasing earnings by $0.10, while B. Puts it to work at 5% only increasing earnings by $0.025.

If their P/E’s remain stable at 10, then A. Share price will increase by $1 while B. Share price will increase by only $0.25.

So your earnings and share price will grow faster at company A. You might also get to double dip in regards to your returns, because when the market finally realised that A is of higher quality. It’s p/e might be rerated to 15, and the share price will spike 50% on top of the growth caused by earnings growth.

You see some people sometimes question why Tesla has a higher PE than Ford, and they assume this means Tesla is over priced, but if you look at some of the underlying factors, you can see that different companies justify higher P/E’s.

The biggest wins often come when you can identify a great company trading on a low PE. You then get two bites at the cherry eg you get to by a low PE company paying great dividends or retaining large earnings being put to work at high returns, but also participating in a big re-rating at some stage in the future.

 

[divs4ever]

This video explains some concepts of value investing and analysis of financial statements.

Using similar analysis to what is described in this video I have found some wonderful opportunities.

goodness me , hasn't WOW gone downhill since 2010 ( except for share price , after real inflation )

 

[Value Collector]

goodness me , hasn't WOW gone downhill since 2010 ( except for share price , after real inflation )

MASTERS really screwed with their numbers for a fair while, they wasted billions.

Which ties into my point, a company has to be deploying its retained earnings at a decent ROE.

If Masters had worked out it would have been a great thing for them, unfortunately it back fired.

 

[divs4ever]

MASTERS really screwed with their numbers for a fair while, they wasted billions.

Which ties into my point, a company has to be deploying its retained earnings at a decent ROE.

If Masters had worked out it would have been a great thing for them, unfortunately it back fired.

i got a nasty surprise when i went into a Dick Smith's Electronics store ( when WOW still owned them ) i had a fair chunk of WOW back then , Master's/and the other hardware brand , and the stumbles after , culminating in a sell-down of 90% of the holding in January 2020

i ALMOST regretted that when they divested EDV , but so far EDV hasn't kicked enough goals to reach that regret , yet

in hindsight i THINK WOW was trying to force growth/expansion ( at any cost )

 

[robertbanking]

Thank you very much for your detailed posts on this subject, you have been more than helpful and i cannot thank you enough. You are all very amazing here.

Knobby22 thats a very interesting point depending on the industry the analysis should be different, in terms of industries like insurance, banking and pharma etc. EPS being a very important metric. Further looking at cash flow, does it need more cash to expand and being particular careful with biotech startups. I truly appreciate your response very much here.

Value Collector thats a very important hint which i will make a note of, i truly appreciate you sharing that in terms of ROE and how this is so critically important in comparison to EPS. Identifying a great company with a high ROE and low P/E can be very rewarding, thanks very much for sharing this, its helped very much with my research. I really liked in particular the example you provided between Company A and Company B to make this more clearer also.

divs4ever thank you also very much for taking the time to share your comments, i am really grateful. I agree time and experience in reading the reports and watching the companies will help, i very much agree. I like how you start with an opinion on the economy and a rough idea of the relevant sector firstly. Thats a very interesting point how words like restructure could mean they have taken the wrong path, companies dont like to scare investors too much and try to keep things optimistic.

Thank you very much to all of you, Aussie Stock Forums i believe is the best forum to continue learning about investing, sharing ideas and research. Wishing you a fantastic day all and sending you lots of good wishes.

 

[The Triangle]

Hello you wonderful and intelligent individuals, i do hope you are doing well and Happy New Year, i hope this year is a good one for you.

I am trying to improve my due diligence process when reviewing stocks, i appreciate everyone will have different protocols. I please kindly wondered when you are reviewing an Annual Report of a company what do you look for to increase the chance of business success please? For instance does the business have competitive advantages etc. Lastly, can i kindly ask is there any other important parts of due diligence to look at which might be very important please? For instance large institutional ownership etc. I would be forever grateful if anyone kindly had chance to get back to me please, it would mean the world to me.

Thank you so much for your time and i do wish you a wonderful day ahead and thanks very much for reading my post.

I usually read the whole report and plug all the numbers into a spreadsheet to work out all the standard investment ratios and KPIs and look at a lot of material outside of the Annual Reports. In general, to increase my chances of 'success' (more so decreasing my chances of a loss) this is roughly what I look at:

• At least 2 Annual reports (2022 AR, and a 2020 AR covering 4 financial years)
• Cashflow statement - Does the company generate enough operating cashflow to pay for all of its capital expenditure, all of its financings, and all of its dividends? Or - is it continually borrowing? The more cash it generates the more likely I think it is to be successful. Obviously, things like Biotech start-ups or junior explorers don't fit this very well. All they do is burn cash, so in this case I just work out their cash burn rate and then look at the balance sheet to see how long they can last before needing revenue or a capital raising or to increase debt.
• Balance sheet - How much cash (or liquid investments) do they have vs debt. If they have a huge chuck of cash, and they generate positive cashflows, then they presumably have a lot of flexibility to either pay increased dividends, buy back shares, invest in growth, pay off debt (reduce interest), or generally weather a bad year or two without going broke. I also look at the other assets like inventory, intangibles, etc. etc. the more they 'have' the more likely they can make moves. Debt is the reverse here - big debt is usually a big concern, but not aways. No debt or little debt usually indicates they have the capacity to borrow safely and spend that money on expanding sales, or reducing costs, or making acquisitions.
• Proft/Loss Statement - This can be manipulated by accounting, so I only roughly care about profit and loss - so long as none of the line items are wildly different year after year and the trends are similar to the cashflows (if profit grows then so should cashflow... often it does not especially when profit comes from acquisitions or things like revaluing biological assets). I also check for one-offs here like lawsuits, write-offs, restructuring costs, etc. Several years ago, the likes of MRM and MCP had big write-offs and big paper losses, but they were actually still generating positive cashflows.
• The notes to the financial statements. Usually, I go straight to the debt/loans (lawsuits pending) and look at the terms and conditions, interest rates, payback periods. If Company A has $1billion of debt due in 1 year and company B had $1billion of debt due in 5 years, then I'm likely going to prefer B over A. I also check the notes when something doesn't seem right in above numbers.
• Offshore/Foreign exposure: Where is the revenue coming from? China? USA? Australia? A mix? Obviously, some countries (China for example) are a big risk, USA generally has more growth potential but more competition. I Also like to know how long they have been doing their business in those respective areas. 20 years? Then you know it's probably reasonably stable. 1-2 years (especially outside of Australia) and you know there is likely heightened risk. ASX companies headed by Australians typically fail in offshore expansion in my opinion.
• Related party transactions. (In the notes) - Not usually interesting for someone big like BHP, but for the little guys it can get pretty incestuous and corrupt - especially in lifestyle junior miners. The MD might employ his wife, lease the office from his other company, loan the company money at a very high interest rate which is not needed (or vice versa, loan himself money cheaply), have yacht parties on his boats paid for by the company. Or maybe their sales growth is coming from one particular customer linked to an executive, or maybe they've overpaid for junk mineral leases and tenements from their mates (you really got to dig to trace that stuff!). This doesn't really tell me the success chance will be higher, usually just flags the company success chance will be lower
• Top 20 shareholders - A curiosity - but I don't really care. As a rule of thumb, I'm worried by one major shareholder (30%+) (someone to bully and corrupt a competent board) or a very fractured top 20 (no one to bully an incompetent or corrupt executive and board)

I'd also add that I read the first half of the annual report but take it with a grain of salt as its always just written to make a company look good. It's usually just filled with silly statistics and the opinions of the executives. And as mentioned in above posts the sector you are looking at is rather significant.