After a decade of surging stock prices and economic growth in what was known as the “Roaring Twenties”, the stock market crashed in 1929. The Dow Jones Industrial Average dropped by 25% and the market value plummeted. This crash was partially a result of thousands of people pouring money into stocks of companies they knew nothing about.
Businessmen and janitors alike embraced the euphoria of investing in companies they were unfamiliar with. These investors were then crushed in the greatest stock market depression of all time.
The Securities Exchange Commission (SEC) passed the 1933 and 1934 Acts to ensure that investors were never misled again.
These Acts required that all public companies submit an annual 10-K report to the SEC to increase transparency.
While the 10-K originally was designed to protect investors, knowing how to read a 10-K has become one of the greatest tools for an investor to optimize opportunity.
What is a 10-K?
One of the main skills of a stellar investor is knowing how to read a 10-K, an annual report that must be filed by a public company following the end of the company’s fiscal fourth quarter. It provides a comprehensive overview of the company’s business and financial condition.
Annual 10-K reports are a company’s single most detailed report, and they contain information that’s essential to determining whether or not a stock is worth your money.
10-K filings can be obtained through numerous mediums, including a company’s corporate website (“Investors Relations” link) as well as through the SEC’s EDGAR and other financial information services.
What Does A 10-K Report Contain?
A typical 10-K consists of a cover page and three main parts:
This includes basic company information such as the name of the company, the market value of voting and non-voting shares held by non-affiliates of the company, and the number of shares of the issuer’s common stock outstanding.
Part I: General Business Information
This includes a description of the company’s business, risk factors of the company (lack of profit, financial position, illiquid securities, etc.), and any current legal proceedings.
Part II: Financial Information
This highlights significant trends in the company’s financial condition and operating results—yet another advantage of knowing how to read a 10-K.
It may include revenue, net income, total assets, EPS, and dividends. Other components of the Financial Information section include:
Management’s Discussion and Analysis of Financial Condition
Otherwise known as MD&A, this comments on the company’s operating performance, capital resources, liquidity, and any other factors that the company considers significant. The MD&A is the lengthiest part of the 10-K.
Disclosures About Market Risk
This includes currencies, commodities, and interest rate fluctuations.
Audited Financial Statements
- Balance sheets as of the end of each of the two most recent fiscal years
- Income statements for each of the three preceding fiscal years
- Cash flow statements for each of the three preceding fiscal years
Part III: Directors, Officers, and Beneficial Shareholders
This part identifies board members, executive officers, and other key employees. Other components of the section include:
- Compensation awarded to executive officers, including cash and non-cash elements
- Amount of securities owned by officers, directors, and any other investor known to be the beneficial owner of more than 5% of the company’s voting securities
Annual Report Versus A 10-K Report
Typically, at the end of a company’s fiscal year, the company will file an annual report alongside its 10-K. While 10-Ks are required by the SEC, Annual Reports are prepared for the annual shareholders’ meeting to help investors make better investment decisions.
In order to attract investors, Annual Reports are more aesthetically pleasing than the monochromatic 10-Ks. They include charts, graphs, and pictures, while a 10-K consists mostly of text and financial tables.
Annual reports provide a detailed business description including a letter from the CEO, a breakdown of key business metrics and financial performance, highlights from the previous year, and goals for the next year. Annual Reports are known to emphasize the positives of the business while minimizing the negatives.
Some companies choose to use the 10-K as their Annual Report to avoid producing two separate documents. Understanding the Annual Report will only benefit investors that know how to read a 10-K.
Understanding How To Read A 10-K
The process of learning the in-depth “story” of the company should be exhaustive, because this information is essential for making decisions regarding the quality of the investment.
It’s critical to study as much company-specific and sector-specific material to get a 360-degree view of the potential investment.
Learning how to read a 10-K is not always a straightforward process. Some 10-Ks, such as Facebook’s 2018 10-K, are over 80 pages.
Luckily, you don’t need to know how to read a 10-K from cover to cover to understand whether or not it’s a good investment.
Follow these steps can help you efficiently learn how to read a 10-K.
Part I: General Business Information
The best place to start when learning how to read a 10-K is with the general business description, because it shows what the top priorities are in the business.
Here are some considerations when reading the business description for understanding how to read a 10-K:
Business descriptions include a high-level overview of how the business operates. The description will include products or services that the company sells, how it generates revenue, its marketing strategy, or any other notable aspects of its operations.
Quantity and diversity of a company’s customers are important. The customer base can be broad, targeted, or a specialized/niche market.
While it is generally positive to have low customer concentration from a risk management perspective, it is also beneficial to have visibility and comfort regarding future revenues.
End Markets and Distribution Channel
A company’s performance is tied to economic and other factors that affect its end markets. Is the company selling through wholesale, retailers, direct-to-consumers, or business-to-business? The end markets and end users are key drivers of operating strategy, performance, and value.
Different regions of the world often differ substantially in terms of fundamental business drivers and characteristics, including different growth rates, macroeconomic environment, competition, and paths-to-market.
Most public companies face significant competition in every aspect of their businesses. As companies introduce new products or services, they can be subject to heavy competition from new market entrants or current competition. The question to ask is how does the company’s business model differentiate itself from competitors?
The Risk Factors section is one of the most important sections to understand when learning how to read a 10-K.
The section highlights aspects of the business that investors could be unaware of. Certain factors may have a material adverse effect on the business, financials, and operations. The SEC requires that public companies disclose these risks.
Risk factors are listed in order of importance. While some risks are standard industry risks, be on the lookout for less obvious, company-specific risks.
Compare company risk factors from year to year. If a risk factor that wasn’t mentioned in the previous year jumps higher up on the list, this could be a warning sign.
Part II: Financial Information
Management Discussion and Analysis
The most important aspect of the Financial Information section is the MD&A. This section provides an executive overview of financial results for the previous year. In learning how to read a 10-K, the MD&A will explain the most notable financial metrics that investors should take into account.
Common metrics include
- customer growth
- revenue and revenue growth
- total costs and expenses
- net income
- capital expenditures
- cash flow
- number of employees
The MD&A explains how the financial metrics tie into the company’s story, connecting quantitative and qualitative information.
The MD&A is an excellent tool for beginning investors who have less experience with financial analysis but want to better understand how to read a 10-K.
Look for positive and negative material changes such as declining gross margins, weakening cash flow, or increases in long-term debt that may need to be examined further.
Studying the Financial Profile
One reason it’s so important to know how to read a 10-K is that it’s the primary source for locating the info necessary to calculate all relevant financial statistics and ratios. The three main financial statements included in a 10-K are the Income Statement, Balance Sheet, and Cash Flow Statement.
- The Income Statement or the Profits & Loss Statement (P&L) shows revenue, expenses, and net profits over a full year.
- The Balance Sheet includes assets, liabilities, and shareholders equity at a point in time. Shareholders equity measures the amount by which a company’s assets exceed its liabilities, at a moment in time.
- The Cash Flow Statement shows the cash generated or used by operating, investment, and financing activities. This statement summarizes changes in the company’s cash position.
When evaluated together, these three statements provide a picture of a company’s financial health, one main benefit of knowing how to read a 10-K.
When studying the financial profile, begin by studying the following:
High growth companies tend to lead to higher valuations. Determine whether the growth is acquisition-driven or organic. Compare the growth rates year-over-year to see if there are any signs of growth slowing down.
Cash can be the most revealing financial metric. The cash flow statement shows whether the company is a user of cash or generates cash. A company can report positive net profit, but negative cash flow which could be a red flag. Companies with stable or increasing cash flow are more likely to be a healthier company.
Profitability measures the ability of a company to convert sales into profit—profitability ratios employ a measure of profit in the numerator and sales in the denominator. Gross profit margins and operating margins are key indicators of operational efficiency and pricing power compared to competitors.
Size can be measured in terms of market value (i.e. equity value, enterprise value, or market cap) as well as key financial statistics.
Size is likely to have an effect on dynamics including economies of scale, purchasing power, pricing leverage, customers, growth prospects, and trading liquidity of shares in the stock market.
Creditworthiness as a borrower shows the ability to make full and timely payments of debt obligations. Credit profiles reveal a great deal about financial policy, risk profile, and capacity for growth.
The higher a company’s leverage, the higher its risk of financial distress.
Key ratios that can be used for comparison against industry standards include:
Debt / Equity Ratio = Total Liabilities / Total Equity Degree to which a company is financing its operations through debt versus equity.
Interest Coverage Ratio = Operating Income / Interest Expense Measures the ability of a company to pay all debt obligations, including payment of principal and interest.
Return On Investment (ROI)
ROI measures a company’s ability to provide earnings to its capital providers. ROI ratios employ a measure of profitability in the numerator and capital in the denominator:
Return on Equity = Net Income / Equity Measures the return generated on the equity provided to a company by its shareholders.
Return on Assets = Net Income / Assets Return generated by a company’s asset base and shows the asset efficiency of a business.
P/E ratios show how much investors are willing to pay for a dollar of a company’s earnings. Companies with higher P/Es than their peers tend to have higher earnings growth expectations.
P/E = current share price / diluted EPS
The Dividend Yield is the Annual Dividend Yield amount of money it pays its shareholders each year, as a percentage of its current stock price.
For example, if a stock's share price is $20 and it pays dividends at a $1 annual rate, its dividend yield is currently 5%.
When analyzing financial metrics, compare them to prior years and against the financial metrics of similar companies.
Part III: Directors, Officers, and Beneficial Shareholders
You can find out more about the management team by knowing how to read a 10-k. The form directs you to the supplemental proxy document.
The most important aspect of Part III is that the company needs to be transparent about how much executives get paid, what perks they receive, and who the involved parties are.
In this section, it’s best to examine CEO and executive compensation packages. Executives that own stock in the company have interests that are better aligned with shareholders.
Bonus packages should incentivize executives to think about long-term, sustainable growth for the company and deter them from making any risky short-term decisions.
Practice, Practice, Practice
Learning how to read a 10-K can be overwhelming. Don’t worry, everyone starts somewhere. Warren Buffett is the most famous stock investor in history. How does he pick stocks?
"Read 500 pages like this every week. That's how knowledge builds up, like compound interest." -Warren Buffett
Buffet says smart fund managers learn to relax by putting their feet up and burying their nose deep in as many 10-K annual reports as they can.
Convinced yet of the importance of knowing how to read a 10-K report?
As you dive into more understanding how to read a 10-K by doing just that—reading one—you’ll begin to notice trends across sectors. Each sector has a set of key characteristics that can be used for comparison purposes.
While the framework is not exhaustive, comparison of the most relevant metrics provides insight into the target’s business and financial performance relative to the sector.
Learning how to read a 10-K provides the ability to examine the whole story of a company. It puts the power in the hands of the investor to know exactly what they are investing in.
True investors are educated and know where their money is going. Don’t make investment decisions based on what other people tell you. Take control of your money and your life.
Tucker Ammons is an investment banking analyst at Bourne Partners, a boutique investment bank in Charlotte, North Carolina.