Expecting to invest successfully in a company like the one discussed in the prior post http://wp.me/p2OaYY-1ub would be like expecting to win at this game (turn up the volume):
One trick that has helped me when analyzing a company for the first time is to go right to the back of the financial statements and look at the figures before I read what the CEO has to say. Be careful of hearing the story before you look hard at the numbers. Accounting is a rules based system that management can use (legally) to obscure economic reality from those who do not connect the numbers. Practice will help.
Let’s hear what a Pro (a reader, AGEDWISDOM) has to say:
This post should be a supplement to a two-year course in learning how to invest http://wp.me/p2OaYY-1u1
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Purpose of this Article
When beginning the journey of value investing, one of the more technical questions that every non-accountant or non-finance personnel might face is the dreaded necessity to interpret financial statements. This post is a primer to get you started on the path to financial statement analysis. Rather than trying to read 50 books on accounting and getting hopelessly lost, this article can serve as a map in times of distress (or when you want to rip your hair off) in trying to interpret some arcane financial statements. Let’s get started, shall we?
Who am I?
Suffice to say, I am an accountant trained in the British tradition somewhere in Asia which means I’m more used to IFRS (accounting standards for mostly the rest of the world) as opposed to those trained in the US. With the convergence of accounting standards worldwide, there’s not that great a disparity between accounting standards between countries anymore. I have worked as an auditor for some years, so you can have some comfort in what I say. But as the saying goes, “Listen to everyone but judge for yourself”
Questions, questions and more questions
When you start your journey with value investing, you’ll be asking yourself many questions but the basic three might likely be:
1. How important is financial statement analysis to value investing?
Very. For those of you that have been following John’s blog, you can see a common thread in many of his posts. And that is, the X-Files motto (cue in the theme song…), “Trust No-one”. At the risk of sounding cliché, the financial statements is literally the last bastion of objectivity in the reporting of financial results.
What I mean by this is that if you rely on secondary sources, you’ll very likely run into people with interests or bias that may misinterpret the results for you. A prime example would be financial newspapers. Since most of these papers are owned by large conglomerates, they tend to report on the positive sides of things and keep the less savory things hidden. Prime example might be the recent Facebook IPO.
2. Is there a formula, models or a short-cut to interpreting financial statements?
No. There’s a very good reason for this.
Short-cuts, instant results… I’m too busy (ugh! typical mentality these days…) Whatever short-cuts or formulas that you intend to use… my advice, better BEWARE! You see, although financial statements is the so-called last bastion of objectivity, this doesn’t mean that the bastion is under daily assault by aggressive CEO’s and their Financial Controllers that do their darn best to try to present a pretty picture when it’s anything but. These CEO’s know whatever beautiful models that the analyst use. In the hands of a capable accountant, it’s entirely possible to subvert or render certain models useless.
Look in layman’s terms – it’s pretty simple. Let’s say my criteria for a value investing book is based Graham’s Security Analysis. Now, I find that I want to buy other good value investing books… but I want to know FAST… I want SHORTCUTS. I don’t actually want to ask other people or skim through the book (too busy, you see…), so using Graham’s book as a sample, the book must be:
1. Over 600 pages long
2. Be prohibitively expensive.
3. Have some foreword by prominent value investors of the day
Now, if a million other value investors use this so-called short cut as criteria to buy books on value investing, what will likely happen is that some publisher will start churning out huge amounts of titles to cater for these short-cuts… So, the publisher will in a sense pervert whatever models or indicators that you are using. These books could be utter rubbish, for all you know.
Hope I’m clear.
3. Why is it so mind-boggling, so arcane, so supercalifragilisticexpialidocious?
Elementary, my dear! It’s designed to be that way silly. We need to have some barriers of entry don’t we? Otherwise, a lot of professionally trained people would be out of a job.
Seriously though, the financial reporting world is much like an arms race. On one hand, you have the accounting profession trying to report results objectively and consistently. Unfortunately, on the other side, you have very aggressive, highly intelligent and extremely well paid consultants, accountants and investment bankers that find very creative ways to report profits in both good times and bad. Guess who’s winning the war?
As such, financial statements are becoming more and more complex, especially for those companies listed on the stock exchange.
Your job as a value investor is to attempt to separate the wheat from the chaff and attempt to weed out the distortions and look at the company’s results in an objective view so that you can access the value of the company.
The Journey
My advice on learning accounting is less reading, more doing. What do I mean by that? Financial statement analysis is a language on its’ own. Granted, it’s a more esoteric form of language but it’s still a language – the language of finance. You don’t learn a language by reading it but by applying it!
So, start small. Take baby steps. Grab a hold of financial statements of companies you are intimate with. These could be companies you are currently working in, or those you used to work for. It could be the financial statements of your relatives’ business. Something, anything…
Get 3-5 years’ worth of financial statements. Go through these financial statements and see what you can glean out of it. Find out how much you do know or don’t. Then, get a good book on financial statement analysis that you like and use it to help you analyze the financial statements further.
Write a short report summarizing what you think happened to the company during the 3-5 years. Was the sales improving? Are margins improving? Are profits improving? Are cash flows improving? More importantly, why, why, why? After that, talk to the person in-charge of the business and see whether your understanding of the business from interpreting the financial statements was correct or wrong. This will help you sharpen your skills when you tackle listed companies later on.
The Bottom-Up Approach
I am a firm believer of starting from the bottom up. Try to understand the nuts and bolts of interpreting financial statements especially the cash flow statement. No point trying to analyze the financial statements of a huge multinational with operations spanning several countries with hundreds of businesses and subsidiaries that run into several hundreds pages when you haven’t even tried your hand at something simple, yes?
Yes, you can start with a top-down approach later on… but always try to start with something small and build up on it.
Books, what Books?
Rather than starting with books, I suggest simple exam questions of accountancy bodies that try to test students abilities to interpret financial statements. That way, you get to try to speak in the language of finance and see how good you really are at it. There’s an added benefit of not dozing off whilst reading those books on accountancy…. phew… some are great (at putting people to sleep 🙂
Conclusion
So, there you have it. My 5 cents view on accounting. Hope it’s a useful guess post. Take it for what you will and hopefully, some of you find some value to it. Good luck!
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Also, http://www.oldschoolvalue.com/blog/book-reviews/basics-of-understanding-financial-statements-3/
GMO 3Q 2012: JG_LetterALL_11-12 (2)
Understanding Equity Returns: BI_Explaining_Equity_Returns_812
Retail Stocks (Buffett and Beyond): Buffett and Beyond November+2012