A lesson from Enron.
Much is being made now, rightly, of Enron's accounting and reporting. Even if they had perfect accounting, however, this one was an accident waiting to happen. Enron very rarely earned any true profits (free cash flow) even though they consistently reported growing profits. Over the period from 1991-2000, they were weakly FCF positive in only four of those years. Because they never earned any true profits, they were forced to fund their operations through equity dilution and ever rising debt.
Things we can watch for with companies we investigate:
1) Are they making real profits (free cash flow)? If not, we should at the least set expectations as to when they will, and how much. A G or K should be profitable. If CAPs and GAPs are expected to decrease, then this point becomes even more critical; if the profit window is smaller, it better not be wasted.
2) How much are they funding their operations with equity dilution and/or debt? If the company is not yet earning true profits, this is necessary. If the company has a well established position, this should be minimal at most. At the least, we should calculate how large their benefit from dilution is relative to their true profit, and weigh it against our own expectations for the company given its competitive position.
3) How simple are their financial statements to read? While they all may seem alien if we haven't tried reading them before, even with no familiarity we can distinguish between them. Look at the statements as filed with the SEC, as those accompanying earnings releases are simplified. Some companies manage to very concisely lay out their finances, while some need pages and pages of footnotes. At the least, very complex statements should serve as a cautionary flag.
4) Read the proxy statement. Most have probably been told at one point that they should not invest without having read an annual report. I'd take it one step farther and say don't invest until you have read the proxy statement as well. The proxy, more than the annual report, will give you insight into the rationality of management, and will alert you to possibly suspicious transactions or relationships.
We can greatly reduce our risk of disaster if we do a little homework in advance. None of these take so much time as to prevent our making a decision or plenty of profit if the company turns out to be good.
- Pirah |
