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Accounting 101: Reading a Company

Annual Report like Warren Buffett

Posted on September 5, 2014

If you think you can be a great investor, you’d better enjoy working with one of the principal

tools of the trade: Reading companies’ Annual Reports. Berkshire Hathaway’s Warren

Buffett has said he loves to curl up with companies’ annual reports. When asked how to

get smarter, Buffett once held up stacks of paper and he said “read 500 pages like this

every day. That’s how knowledge builds up, like compound interest.”

Indeed, smart fund managers think of Company Annual Reports as puzzles or treasurehunts and relish the chance to dig through even the microscopic footnotes.

We retail investors may not have the same advantage as a fund manager, who looks at

hundreds of these filings year after year. So to help the individual investor know what to

look for when considering stocks for their portfolio and when reviewing the outlook for

current stock holdings, I’ve put together a simplied version of accounting 101.

A final word to the wise: If you don’t enjoy the depth of research requiring some simple

accounting described, you might want to consider whether stock picking is the best use of

your time. You probably won’t be a great investor unless you love annual company reports

enough to want to read them on a plane trip. Fund managers love it, it’s a passion they

have that when they hop on a plane on business, they’ll take a few reports stuff them into a

bag and read them like enjoying a book.

Simplied Example of a Company’s Annual Report (trust me the real one is like greek but

we only need to look at these key figures) :

Oracles of a Stock Operator

A fountain of Investing Wisdom



When analysing the three financial statements in a company annual report, here’s what to

look out for:

1)Gross Profit Margin: Gross Profit / Sales = 1,500,000/ 10,000,000 = 15%

Proportion of money left after subtracting cost of goods sold. The higher the margin, the

more profit a company retains from every sale. Look out for Gross Profit Margins of 15%

or more or compare with industry benchmarks.

2) Net Profit Margin : Net Profit / Sales = $800,000/ $10,000,000 = 8%

Proportion of money left after subtracting all expenses. The higher the margin, the more

profitable overall a company is. Look for Net Profit Margin of 8% or more, or compare

industry benchmarks.

3) Return on Equity (ROE): Net Profit / Shareholder’s Equity

= $800,000/ $4,000,000 = 20%

How much profit a company makes from shareholder equity. The higher the ROE, the

better the company is at generating profit for shareholders. Look for ROE of 15% or

more.

4) Current Ratio: Current Assets / Current Liabilities = $3,000,000/ $2,000,000

Measures a company’s current assets against its current liabilities. The higher the ratio,

Financial Statement of a Company —

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the more current assets the company has to pay off its current liabilities, which reduces

risk. Look for a Current Ratio of 1.0 or more.

5) Cash Ratio: Cash / Current Liabilities = $1,500,000 / $2000,000 = 0.75

Measures a company’s cash position against its current liabilities. The higher the ratio, the

more cash the company has to pay off its current liabilities, which reduces risk. Look for

a Cash Ratio of 0.5 or more.

6) Debt to Cash Flow Ratio: Total Debt / Operating Cash Flow

= $2,200,000/ $1,000,000 = 2.2

Measures a company’s debts against its operating cash flow. The lower the ratio, the

better the company’s ability to finance its debts from its cash flow. Look for a Debt to

Cash Flow Ratio of 3 or less.

7) Net Gearing Ratio: (Total Debt – Cash ) / Shareholer Equity

= (2,2000,000 – $1,500,000) / $4,000,000 = 0.175

measures a company’s debts against its shareholder equity. The higher the ratio, the more

debt and risk the company has. Look for a Net Gearing Ratio of 0.5 or less.

8) Dividend Yield: Dividend per Share/ Share Price x 100% = $0.04/$1.00 x 100% =4%

Measures how much dividends the company pays out compared to the stock price.

Usually companies that pay out more dividends are cash rich and have little need for cash

to be reinvested. Look for consistent dividend yields between 4-8%.

9) Earnings Per Share(EPS): Net Profit/ No. of Shares =$800,000 / $10,000,000 =

$0.08

Portion of company earnings allocated to each share. The higher the EPS, the more

profitable the company on a per-share basis. Look for stable and consisten EPS

growth( assuming the number of shares remains the same ie. no rights issue or

coporate actions).

Points to Note:

When looking at financial statements and ratios, compare them with industry

averages to ensure they’re not too far off from industry benchmarks.

Consistency is key, For example if a company’s ROE is 35% one year and 5% the

next year, then back up to 20% and then down to 10%, that should give you a red



flag.

Never use just one or a few ratios, use all the ratios in conjunction with each other

to paint a fuller picture of a company’s financial position.

You can always use fundamental analysis tools on websites like Yahoo Finance or

ShareInvestor.com to help you with your research on a company’s financial statement or

ratios.

Pricing a Company & different ways of Valuation:

You’ll need to calculate the intrinsic value of the company and compare that to its stock

price to determine if the stock is undervalued.

There are many valuation methods out there but there are 4 that are commonly used:

1)Price/Earnings (P/E) Ratio: Share Price/ Earnings per Share = $1/ $0.08 = 12.5

Measures the price paid for a share relative to its earnings. A high P/E ratio does not mean

that you getting a stock that is more “expensive”. A good stock investment could have a

high P/E ratio because investors expect high growth and better future earnings. But if that

growth does not pan ouit, stock prices are likely to fall drastically.

A low P/E ratio does not mean a stock is “cheaper” and possibly undervalued. In general it

is better to look at a stock’s historical P/E ratios over the years and buy when there is asignificant drop due to market over-reaction to a poor economic outlook which affects the

entire stock universe.

You always have to compare a stock’s P/E ratio with industry averages to gain a clearer

benchmark. A high P/E does not mean a stock is over-priced.

2)Price/ Earnings to growth (PEG) Ratio: P/E / Annual EPS growth

= 12.5/ 25%* = 0.5

Measures a company’s P/E against its annual EPS growth. The higher the ratio, the more

expensive the stock is. In general it is better to buy a low PEG stock than a higher PEG

one, all else being equal. A PEG ratio of 1 indicates fair value. Look for a PEG Ratio of

0.5 and below.

3) Price/Book (P/B) Ratio :

(Share price x No. of Shares)/ (Total Assets – Intangible Assets* – Total Liabilities)

= ($1 x $10,000,000shares) / ($8,000,000- $500,000 – $4,000,000) = 2.86



Intangible assets* are assets that are not physical in nature like goodwill, trademarks,

patents and brands

Compares the company’s market value with its book value. Book value is the total

accounting value of a company’s assets. A low P/B ratio could mean a stock is

undervalued. It could also mean something is fundamentally wrong with the company. This

valuation method is usally ONLY used for Asset Plays – when a company’s assets are

worth more than the company itself. When using this ratio, it’s important to define the

tangible assets that can be easily liquidated. For example, assets like real estate can be

easily sold, but plant and machiney are much harder to. A P/B ratio of 1.0 indicates fair

value. Look for a P/B ratio of 0.5 or less.

4) Discounted Earnings/ Cash Flow Model (DCF)

A Discounted Cash Flow Model assumes that a company’s intrinsic value is the sum

of all future earnings or cashflows discounted to their present value. If this value is

higher than the current share price, then the stock is undervalued.

$100 invested today at 5% interest is worth $105 one year from now. This means $105

received one year from now is worth the same $100 received today. Similarly, $100

received one year from now is worth the same $95.24 invested at 5% interest today

because $95.24 invested at 5% interest today would be worth $100 one year from now.

This is known as the time value of money – because of interest rates and inflation, every

dollar received further an further in the future is worth a smaller and smaller amount today.

Let’s assume a company’s earnings per share is $1 every year for the next `0 years with

no growth. With a risk-free rate of 5%( bank fix deposit rate or highest rate you can find

without risk), the company’s total discounted earnings over 10 years would be $7.71

Since a company’s intrinsic value is the total of all future earnings. then its intrinsic value



is now $7.71. If the share price is below this intrinsic value of $7.71 then it is undervalued.

Projecting a company’s future earnings is never easy, but with some conservatism, this

model gives you a fairly accurate way to gauge a company’s intrinsic value.

Which ever method you use to determine a stock’s intrinsic value, you want to have at

least a 50% margin of safety before you invest in any stock. A sizeable margin of safety

provides room for error in your investments. It protects you from any poor decisions or

downturns in the market.

Personally I’m not so much a fundamental person when it comes to investing as my

patience and time horizon for investing is shorter then what a value investor requires which

is around minimally 3 to 5 years. For me waiting that long for a 20-50% pa. return is not

appealing due to the loss opportunity cost of having your funds tied up. Most people are

unlike Warren Buffet unfortunately and do not have massive funds to acquire a huge stake

in a company and be able to support their prices to withstand the downturns of the market.

Remember the market can remain irrational and unsensitive to the actual worth of a

company for a long time before the company comes into the lime light of CNBC &

Bloomberg news and achieve celebrity status much like a newly discovered talented actor

or singer. Imagine an under-valued stock like a painting ‘s value which is recognized only

many years later after the artist is dead. Leonardo Davinci lived a poor man in his living

days even having painted Mona Lisa, the most valuable art piece ever painted. Would you

rather be like Micheanglo or Picasso who painted what was appealing to the people of their

era, produced and sold many brillant works and lived fulfilling and prosperous lives.Everytime I think of Van Gogh it’s really sad for someone so talented to have only sold a

single painting in his lifetime before his work was recognized.

But if you are a Long-term Investor and have a keen eye for fore-telling the prospects of a

company 3-5 years down the road, you might have a very exceptional talent. But be sure to

have the patience to wait it out and conviction to stay invested even if the market turns

against you. If not you are more suited to be a short to mid-term trader and see short term

opportunities to profit consistently over and over again. That would put you in a different

school of investing called Technical Analysis where much work is done looking at chartsinstead of Annual Reports.

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