This chapter will begin with two pieces of advice to the investor that cannot avoid being contradictory in their implications.
The first is: Don't take a single year's earning seriously.
The second is: If you do pay attention to short-term earnings, look out for booby traps in the per-share figures.
If our first warning were followed strictly the second would be unnecessary.
The second is: If you do pay attention to short-term earnings, look out for booby traps in the per-share figures.
If our first warning were followed strictly the second would be unnecessary.
But it is too much to expect that most shareholders can relate all their common-stock decisions to the long-term record and the long-term prospects.
The quarterly figures, and especially the annual figures, receive major attention in financial circles, and this emphasis can hardly fail to have its impact on the investor's thinking. He may well need some education in this area, for it abounds in misleading possibilities.
A few pointers will help you avoid buying a stock that turns out to be an accounting time bomb:
Read backwards.
When you research a company's financial reports, start reading on the last page and slowly work you way toward the front. Anything that the company doesn't want you to find in buried in the back-which is precisely why you should look there first.
Read the notes.
Never buy a stock without reading the footnotes to the financial statements in the annual report.
Usually labeled "summary of significant accounting policies," one key note describes how the company recognizes revenue, records inventories, treats installment or contract sales, expenses its marketing costs, and accounts for the other major aspects of its business.
In the other footnotes, watch for disclosures about debt, stock options, loans to customers, reserves against losses, and other "risk factors" that can take a big chomp out of earnings.
Among the things that should make your antennae twitch are technical terms like "capitalized", "deferred," and "restructuring"-and plain-English words signaling that the company has altered its accounting practices, like "began", "change," and "however."
None of those words mean you should not buy the stock, but all mean that you need to investigate further. Be sure to compare the footnotes with those in the financial statements of at least one firm that a close competitor, to see how aggressive your company's accountants are.
Read more.
If you are an enterprising investor willing to put plenty of time and energy into you portfolio, then you owe it to yourself to learn more about financial reporting. That's the only way to minimize your odds of being misled by a shifty earnings statement.
- The Intelligent Investor, Benjamin Graham
