The ten-minute annual report - Part 1

It’s that time of year again—your mailbox is about to fill up with annual reports. If you find this prospect a little daunting, then read on.

No matter what type of company you’re looking at, be it a bank, a tin pot gold explorer or a fast-growing retailer, the first steps to examining an annual report are always the same: put the kettle on and clear off your favourite chair. Before you settle in with your cuppa, make sure you have a sharp pencil and a calculator to hand. Also, grab a newspaper (or check the internet) and note down the share price of the company in question. Now we’re ready to start.

The first number to dig out is the number of shares on issue. Flip through the report, ignoring the glossy pictures at the front, until you arrive at the accounts. We’re looking for the balance sheet, which will probably be the second statement, after the income statement (otherwise known as the profit and loss account).

Nitty gritty

Scan down towards the bottom of the balance sheet until you reach the ‘Equity’ section. There you should find a line which reads ‘Issued capital’ or ‘Contributed equity’ or somesuch. To the right of the text should be a number under the ‘Note’ column. Remember this number (it will probably be note 20-something or even 30-something if it’s a larger company).

The bulk of the pages following these main financial statements are the official notes, which contain the nitty-gritty details. In this case we’re looking for the detail relating to the issued capital. Just wade through the notes until you reach the one you’re after. In this section, you should find the number of ‘fully paid ordinary shares’, which is what you’re looking for. Multiply this by the share price you jotted down earlier.

You’ve just calculated the stock’s ‘market capitalisation’, which is the value investors are placing on the company. Knowing this figure puts all the other figures in the report into context. When dealing with large companies, you can easily get swept away looking at the billions of dollars in profits and assets. So by starting with the market capitalisation, you can inoculate yourself against any unfounded optimism by having a proper sense of scale.

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Who owns the company?

Next let’s take a trip right to the back of the annual report. We’re in search of the list of ‘Top 20’ shareholders. If not right at the back, it should be close to it. As you might imagine, this tells you who owns the company. Are there any names you recognise? Is it majority-owned by an individual or another company? Has the top 20 changed much since last year?

Now we have a sense of the company’s market value and share ownership, let’s have a look at those charged with overseeing it—the directors. Before the financial statements but after the glossy stuff, you should find the ‘Directors’ Report’. It should list the various directors, together with their qualifications and experience, and their remuneration and level of share ownership.

Trusting the board

It can be revealing to multiply each director’s shareholding by the current share price, and then divide the result by their annual remuneration. This shows how many years’ pay the director has at stake in the company. Three years is not a bad benchmark.

Corporate governance academics may tell you that directors with large shareholdings have a conflict of interest, but that’s rubbish. A director’s interests should be aligned with shareholders’ and this is only helped by a decent-sized shareholding.

There’s more detail on management issues in Trusting the board, a handy special report describing some techniques to help you assess directors and management.

The next step is to head to the glossy section at the front of the report and read the commentary from the chairman and the chief executive (or managing director or whatever they choose to have printed on their business cards—some can’t decide and call themselves both).

Management clichés

Unless they’re completely frank, which is rare, it’s hard to judge this stuff in isolation. What you need is a few years in a row so you can see whether it’s consistent or not. Are any objectives specific and measurable, or are they all wishy-washy motherhood statements? Is the writing helpful and clear or is it chock-full of meaningless management clichés? For some shining examples of candid reporting, take a look at Servcorp’s annual reports—particularly the one for 2002 when things weren’t going too well.

Anything worth conveying to shareholders should be capable of being expressed clearly. So, if it’s not making sense, then that’s probably because management doesn’t want it to. Bad management doesn’t necessarily make a bad investment, but it’s not a good start and it’s essential to know where you stand.

That wraps it up for this issue. In part 2 we’ll look at some pointers relating more directly to the accounts and the numbers themselves.

Greg Hoffman

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