Over the course of March, we’re due to see a large proportion of the S&P500 publish their annual 10-K reports. Many investors dismiss the 10K as “backward looking”, but for those who are willing to make the effort there is a wealth of valuable information. I’m always amazed by the number of professional investors and analysts who never read the annual report, choosing instead to get all their information second-hand from Bloomberg or Reuters. In my opinion, that’s a big mistake. And it also represents an opportunity for those who dig a little deeper. Here are 10 things that I always look for in a 10K report.
- Management Discussion and Analysis
One of the most valuable sections of the 10K report. I read it with a mind to two separate things:
- What metrics does management track? This gives us a strong clue as to what they view as the key drivers behind the business
- Study management’s tone. Are they open in their communication? Do they discuss what went wrong, as well as what went well? Do they discuss challenges as well as opportunities? These are signs of a strong management team who are constantly considering the threats to a business and trying to learn from their mistakes.
- Risk Factors
This section is infamous for its high “noise to signal ratio”. About 80% of this section is nonsense that has been written by a team of lawyers, either stating the obvious or repeating the same point several times over. However there is valuable information in the other 20%, so make sure to study it. The more specific the risk factor, the more relevant it’s likely to be. Also look for changes in this section compared to the prior year – this may flag a threat that has recently become an issue for the company.
- Notes to the Accounts
The notes to the accounts are probably the most valuable section of the entire 10K, but also the most time-consuming to analyze. While the financial statements represent information that has already been reported, the notes to the accounts often contain new information. If anything in the 10K is going to move the share price, then you’ll find it here. Analysts will often go back and adjust their models after seeing the granularity provided in the footnotes.
- Segment Analysis
Segment analysis is usually found in the notes to the accounts, and is provided by division and by geography. Because financial models are usually constructed at the divisional level, this information is highly valuable as an input for these models. The granularity provided is usually better than found anywhere else.
- Summary of Accounting Policies
This is usually the first note within the financials statement. Much of this section will cover the standard accounting policies that all companies adopt and so is unlikely to be of much interest. However there are a few sections of this note that warrant more attention:
- Revenue recognition policy. Is there anything unusual in the revenue recognition policy? How does it compare to peers and are they being particularly aggressive? Has anything changed from previous years?
- Treatment of intangibles. If intangibles are material to the balance sheet, it will be important to pay attention to this note. Which intangibles are capitalized on the balance sheet and how are they amortized? Note that outside the US, accounting standard often allow the capitalization of R&D.
- Depreciation Policy. Over what time period are assets depreciated? How does that compare to peers?
- Commitments and Contingencies
This section of the 10-K involves a high level of subjectivity, it can contain market-moving information and therefore it tends to cause the most arguments with the auditors. In many cases there will be nothing material here, and you can largely ignore it. However where the numbers are material this note deserves a detailed review. Note that further information may be hidden in the “Legal Proceedings” section (which itself may be hidden in the proxy statement). Under “commitments” you will also find details of any operating leases, which are likely to be highly relevant for certain types of companies (like retailers).
The detailed debt note will give a wealth of information on the terms of outstanding debt instruments and the maturity profile. Again, this is crucial information for anyone building a financial model. A company with a high level of debt falling due in the next 12 months deserves particularly careful consideration.
- Reconciliation to GAAP
This reconciliation is often contained in the management discussion and analysis. It will reconcile GAAP measures of profitability to management’s own measures. It provides a clear snapshot of what non-recurring items management have excluded from the numbers they present to investors. If the management are constantly excluding one-off items, or materially manipulating GAAP measures in some other way, then it should raise a red-flag.
- Income Tax Reconciliation
Determining the appropriate future tax rate is key to building a reliable DCF model. The tax reconciliation table should provide you with all the information needed to do this. Depending on the mix of international and domestic operations the marginal tax rate can change quite meaningfully over time.
- Management Compensation
Management compensation is usually found in the proxy statement. While some analysts focus on the absolute amounts paid to management, I think it’s more important to look at the incentive structure. How many shares do they own outright versus restricted stock versus share options? Where they own share options what are the vesting criteria? Beware particularly complex schemes which create perverse incentives for management. As much as possible you want management’s incentives to be aligned with shareholders (so outright ownership is always better than share options)