What Beginners Should Look For in an Annual Report or Prospectus
So you want to buy some shares, and you’ve decided to try reading an annual report or prospectus. I’m glad to hear it. This is a great way to expand your vocabulary, and learn 25,000+ ways to say “maybe“, and “not my fault”. Also, to determine if a company’s a gold mine (or land mine). Here’s what to look for:
Is an Annual Report the Same as a Prospectus?
Not exactly. A prospectus is a document used to attract potential investors, whereas an annual report is an ongoing “report card”.
The prospectus is a monster document, which takes more time and effort to get through. It encompasses a mind-boggling range of details: capital and operating expenditures, company history since ancient Greece, lists of tangible assets (which threaten to go down to individual paperclips), etc.
When buying shares in a company or fund that just made its Initial Public Offering (IPO), you will have to go through the prospectus.
An annual report is a document given to existing shareholders. It updates you on changes to a company or fund, as well as on the past year’s performance. Investors almost always look at annual reports (but not always the prospectus), before buying shares in an established fund or company.
The Very Basics: What am I Even Looking For?
What follows is a basic and rudimentary guide. Please do not read it, and then dive into the stock market imagining you have a clue. By all means, know these terms; but check your interpretation of them with your stock broker or financial advisor.
You should look for:
- The CEO’s Statement
- The Auditor’s Report
- Financial Statements (Profit and Loss)
- The Balance Sheet
If you are reading a prospectus, you also need to note the size of issue.
1. The CEO’s Statement
I don’t understand why it’s called a “statement” when it’s longer than my university entrance essay. But this section highlights what the company’s been up to, and what its immediate plans are.
(There may be other names for this section, like “Chairman’s statement”. But the general idea’s the same; it’s blather from the person running the show).
If you have the time, read the entire thing. If you’re in a hurry, pay attention to the first two to three paragraphs, and the last paragraph.
Key words to watch for are:
- New venture
- Despite (suggests something went wrong)
Start getting suspicious when you hear the company’s moving into a new country, trying to move into a new market, or diversifying / changing its products and services. These can indicate a number of things:
First, a company’s earnings might become inconsistent. Capital expenditures and operating expenditures tend to rise, when companies expand and try new things. You should brace for the possibility of falling profits, at least in the short term. Expanding is not always a bad thing, but it needs to be taken in context as well.
Second, compare the company’s new initiatives with previous annual reports (go back five years). If a company is constantly changing its products and services, or re-organizing every time there’s a strong breeze, you might be looking at clueless management.
2. The Auditor’s Report
This is a report by independent auditors. This verifies that the whole document isn’t basically a fantasy novel. Key words to watch for are:
- Contingent upon
- Subject to
- On condition
When the auditor uses these words, read the whole sentence carefully. They may be trying to tell you that:
“This is correct if we assume the managers we talked to were telling the truth. Otherwise, who the hell knows.”
3. Financial Statements (Profit and Loss)
There’s no point reading these in isolation. The financial statements have to be compared with previous annual reports, going back at least five to 10 years (Ask your stock broker or financial advisor for help if it’s too inconvenient to do this yourself).
Don’t just pay attention to earnings. Also take note of the company’s expenses. If the company’s earnings went up by 4%, but its operating expenditures shot up by 12%, that’s still not a good sign.
Likewise, watch out for unusual patterns. One example would be a sudden spike in profits, after a long trend of low earnings. That could indicate a company making an Apple-like turnaround. But it could also mean the company’s dying, and just sold off it’s main factory.
Explanations are in the footnotes. But for beginners, consult a broker or financial advisor. It’s not advisable to try and interpret those technical notes on your own.
4. The Balance Sheet
This encompasses a range of different topics. The two main items to look for are:
P/ B Ratio
This is also sometimes called a Price-Equity Ratio (Don’t confuse that with P/E, or Price-to-Earnings). This measures the stock’s market value to the company’s book value*.
(For a more exact definition of P/B ratios, P/E ratios, NTA, and so on, follow us on Facebook. We will cover these technical terms in a follow-up glossary)
If a company has a P/B of less than 1, it might indicate that the stock is undervalued (probably at a lower price than what it’s worth). A high P/B ratio means the opposite.
Before you even think it, no. A low P/B doesn’t always mean you ran into the El Dorado of stocks. The P/B can also be low because earnings have been sliding, or because senior management is being investigated by the authorities. So while a low P/B ratio is a plus, you do need to find out why it’s low.
*(Again, best to ask a broker or financial advisor).
Debt / Equity Ratio
The higher this ratio, the more money the company owes. This ratio matters for two reasons:
First, it reflects the financial health of the company. If you compare the Debt/Equity ratio over five to 10 years, and see that it’s growing, that suggests something might be wrong. Sometimes, a company may have rising earnings, but the earnings are outpaced by its borrowing.
Second, there’s a chance that earnings will go into paying down debt, rather than into big dividends.
5. Size of Issue
Included in the prospectus, this tells you how many shares a company / fund is issuing. Basic laws of supply and demand apply here.
More shares = lower demand, and the shares will be cheaper. Fewer shares = higher demand, which means prices will rise.
This is a simplified assumption though. How the market feels about a company matters a great deal. If a company’s product or service sucks, the share prices might remain low even if the size of issue is small.
It’s Still a Headache!
It might last for a while. But as you come to learn more of the terms, reading a prospectus or annual report will get faster. Do it often enough, and you’ll soon be going through two or three of them before you down your coffee at lunch.
New investors should get a stock broker who’s willing to educate them; even if it means paying a bit more at the start. For more bite-sized pieces of information, you can also follow us on Facebook (and that’s free!).