When it comes to doing your due diligence before investing, there are a number of things you should be looking out for.
If you’re investing in companies, perusing the 10-K report for the company is one of those items to check.
There is a lot of relevant information to be found in these reports, but at a glance they can seem a rather bulky read. For the serious investor though, knowing what to look for can be well worth the effort.
Let’s take a look at 10-K reports and what I usually look for when reading them:
What is a 10-K report?
A 10-K report is an annual filing which is a legal requirement of publicly traded companies. It is a very comprehensive summary of the company’s activity and must be filed with the Security and Exchange Commission. This report tends to contain much more information than what you will find on a typical annual report.
A 10-K will have information such as the organizational structure of the company, all subsidiaries, holdings, equity and earnings per share. Most 10-Ks will follow a similar pattern or format, so after awhile you will become used to pulling out the information you need. You can look at it as the government requiring public companies to disclose a SWOT analysis on themselves – you will find information about risks, opportunities and current operations.
10-K reports must be filed within 60 days after the end of the fiscal year. They are available freely to the public and can be downloaded online or accessed physically in Washington D.C.
What to look for in a 10-K report
A 10-K report may seem daunting, but you can discover a wealth of information, valuable to your investment decision-making within its pages. Mega-investor Warren Buffett famously enjoys (yes, enjoys!) sitting down and reading 10-K reports. They are a great source of knowledge so that you can learn more about how investing works too, even if you don’t make an investment with the company you’re reading about.
“Read 500 pages like this every day. That’s how knowledge works. It builds up, like compound interest.” – Warren Buffett.
Fund managers and top investors regularly find slots in their days during which to read over 10-K reports. This might even be during a commute to maximize their time. The thing with 10-K reports is that if you don’t enjoy reading them or don’t want to spend the time delving into the nitty-gritty of potential investments, picking out stocks to invest in might not be the best investment of your time or money.
That being said, everyone needs to start somewhere – those top fund managers learned their trade by repeatedly monitoring, reading and digesting the information needed to become an expert, such as those 10-K reports.
Here are a few specific areas to pay attention to when reading a 10-K report:
Manager’s discussion and analysis (MD&A)
This is a summary by the principals that give me a great overview of how the company operates. From financial highlights to corporate initiatives and acquisitions this is how I get a fully-formed picture of the company.
You will also note exposures to risks just from this summary and can anticipate how the company performs in different environments. If you want a really comprehensive picture, many top investors will read the last few years of 10-K reports, looking at the chairman’s letter and seeing how strategies have been executed over time.
Did those strategies work?
How has the company had to pivot?
I like companies who get straight to the point without trying to gloss over any failures or less-than stellar performances. This shows a willingness to be transparent and to find ways to improve. It would be worrisome if a company consistently blamed external factors for poor performance without taking the opportunity to be introspective and look for the ways they contributed to the failure. Look for whether any reported cash flow problems or risk factors are likely to be permanent or temporary.
Another red flag would be if a company is changing their messaging each year. If they are flip-flopping or if new risk factors are being added (such as pending lawsuits), you know their lawyers have advised them that those need to be in the report and they’re something you should be paying attention to.
The cash flow statement is the real truth of the company. I look for their free cash flow and how that is made up. The formula below shows how that is calculated:
Cash provided by operating activities – Capital expenditures – Cash dividends = Free cash flow
If a company is having trouble maintaining its previous cash levels, that issue may or may not be a sign of trouble. It may mean that the company decided to maintain lower cash levels and invest in new opportunities, or it may mean that it’s having difficulty generating new cash.
The details of cash flow are important to get into to ensure you have the real picture. For example, a company might report massive gains in income, but this will mean nothing if they are hemorrhaging cash. The other thing to note is how much they are borrowing – loans cost money, and while they might make the company cash flow look good for a while, this is always going to be a temporary state unless they’re making up for it with income.
Look through the consolidated financial statements to ferret out any information related to risk factors that have been discussed as well. For example, what if a company earns more than 50% of its income from just a few key accounts? I’d consider that a significant risk factor if one or two customer relationships souring, or departing for other reasons could take the company for a dive. (You can usually find “Risk Factors” in the middle of Part 1 of a 10-K report).
Debt to equity ratio
This measure is a company’s total liabilities divided by its shareholder equity.
A Debt to Equity ratio of 2:1 means that the company has two dollars of debt to every one dollar shareholders invest in the company. In other words, the company is taking on debt at twice the rate that its owners are investing in the company.
The question “what is a good debt to equity ratio” tends to have an answer that varies according to the industry. As a general consensus, anything above 2:1 tends to be seen as very risky, although there are a few exceptions, such as very large companies in asset-heavy industries.
All of these companies are required to be independently audited and you will find an auditor’s report either near the end or within the notes. Look for the auditors to be agreeing that the financial statements accurately reflect the company’s position and generally that the auditor isn’t questioning their future ability to remain in business.
In the middle of Part II of the 10-K you will find a section for “Auditor Changes or Disagreements.” Any change in auditors or disagreement with the numbers should be considered a big red flag, as is a change in accounting practices (such as in how revenue is recognized).
The proxy statement accompanies the 10-K report and provides information on how executives are compensated. A question to ask yourself is “are senior executive’s priorities aligned with shareholders?” This can be reasonably answered by checking to see how much they have invested personally in the company.
Check the “other” category to get an idea of whether the company might have a culture of abusing perks. This will show items such as vehicles, company jets or company-owned real estate.
Another section to check here is “Certain Relationships.” You should find any information pertaining to possible conflicts of interest, such as if a major supplier or customer is a relative of an executive.
This section really helps to give a good idea of the character of the company. Do they seem to operate with integrity and transparency?
The 10-K report is no light reading (it may even be a cure for insomnia!), but getting practiced at reading through them and picking out relevant information for investment decision-making is a good plan for stock investors.
Look for discrepancies, risk factors, cash flow and the overall integrity of the company and preferably, read a few years of their 10-K reports to look for patterns.