I Used to Struggle to Read Annual Reports
Until I discovered this 6-step process
From “The Dean of Valuation” Aswath Damodaran
On what to look for and why, when trying to value a company
Here it is:
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Before you open an annual report have a purpose.
Ask yourself:
What am I looking for?
When I read an annual report, it’s to help me value the company.
In order to value a company, I need to know what drives value.
There are 5 main things:
1. Current cashflows
2. Growth from new investments
3. Quality growth from improved efficiency
4. Length of the high growth period
5. Risk
Now that I know what drives value, I can figure out what I need to look for in the annual report.
Current cash flows I want to know:
– How much capital is invested in existing assets?
– How much did the firm earn from these assets?
I look for:
– Revenue
– Earnings
– Capital Invested (debt + equity – cash)
Future growth:
– How much growth was from new investments?
– How much growth was from improved efficiency?
I look for:
– Revenue growth
– Operating margin
Quality growth:
– How much new capital will the firm have to invest to deliver growth?
I look for:
– Amount reinvested
– Return on invested capital (ROIC)
Risk:
The 2 types of risk that concern me are:
1. Operating risk – problems with the companies core business.
2. Financing Risk – problems with the way the company is funded.
Operating risk:
– What industries does the company operate in?
– What countries does the company operate in?
Things I look for:
– Relative risk (beta)
– Equity risk premium
– Cost of capital
Financial risk:
– How much debt does the company have?
– Are there any other contractual commitments?
I look for:
– Debt ratio
– Cost of debt
Finally I want to know if there are any other assets or claims.
– Are there non-operating assets?
– Are there other claims on the equity?
Things to look for:
– Non-operating assets
– Minority interests
– Options outstanding
Now I know what I’m looking for and why, I can begin the 6 step process of reading the annual report.
Step 1:
Confirm the timing and currency
– what period is covered?
– what currency are they reporting in?
Step 2:
Find the business mix:
– The business segment breakdown of revenue
– The geographic breakdown of revenue
– Specific risks to the company
Step 3:
Find the base inputs for valuation
From the income statement:
– Revenue
– Earnings
– Interest expense
– Tax rate
From the balance sheet:
– Equity
– Debt
– Cash
– Working capital
– Cross-holdings (minority and majority holdings).
From the cash flow statement
– Change in working capital
– Capital expenditures
– Depreciation
– Debt issued or repaid
Step 4:
Keep digging
In the footnotes look for:
– Operating leases
– Rental and other commitments,
– Employee options
– Timing of debt due
– Underfunded obligations (pension and healthcare)
Step 5:
Confirm The Units
– Shares outstanding
– Restricted stock units (RSUs),
– Acquisitions paid for with stock
Step 6:
Corporate Governance
– Any differences in voting rights across share classes
– Special rights or privileges given to insiders
When starting out this process might take you a long time. But the more you do it the better you will become.
Warren Buffett says it takes him about 45 minutes to read an annual report.
I learnt this process from “The Dean of Valuation” Aswath Damodaran. He has a 45 min clip on YT where you can learn it directly.