We can gain such knowledge and information of a company predominantly from their financial statements. When we look for a company with strong management, solid financial positions, earning growth, etc. look no further but the company's report card: its financial statements. Searching for a proper valuation of the stock? Let's begin with the financial statements. Analysts from the entire stock investing/ trading profession analyze and comment on the financial statements of listed companies every quarter. Great investors like Benjamin Graham, Warren Buffett, Philip A. Fisher, etc. read financial statements before further facts finding. In fact, all investing fundamentalists read financial statements.
It is suicidal to practice investing characteristics like "being patient", "being quick to response", etc. without the backing of knowledge and information. It is knowledge and information that provide great investors their unweaved beliefs in their decisions, whether it is being patient or being quick to cut loss.
With knowledge and information, we are able to be patient and to hold on to jewels like Wells Fargo, Walmart, Public Bank, OYL, etc. that can (and had) brought fortune to the stockholders. Without knowledge and information, we psyche ourselves up to "be patient" on Enron, Bestcorp, Omega, etc. and to see our life savings evaporated when these companies failed. Both are being patient, the difference lies in what we know about our investments. It comes from reading the financial statements.
(So don't advice other to BE PATIENT or BE DECISIVE in holding on or disposing their investments. Such advice can only come after knowing the true financial performance and status of a stock. BE PATIENT and BE DECISIVE are dirty investing words without the backing of knowledge and information of a particular company.)
But why, in general, layman investors don't read financial statements? One of the main reasons I suspect is that layman investors basically throw in the towel in believing that performance of stock prices has got anything to do with the company’s financial numbers. Reading financial statements is, sometime, a futile effort in knowing the company performance. Profit numbers are unreliable. They are right. Looking back at 1997 Asia financial crisis and 2000 Dot Com Bubble, failed companies unabashedly manipulate their numbers before their demises. Stock prices crashed before showing any sign of losses, or before the reported profits were rediscovered as losses. The unscrupulous managements cheated in their report cards. It is reasonable for investors to believe that it is useless and meaningless to read financial statements. However, this is not true. There are ways to detect profit manipulation. We, as investors, can definitely detect profit manipulations.
We rely on the numbers provided by the management to make our investing decisions. These numbers have to be authentic and we must have confident in relying on them. To confidently relying on numbers in making investing decisions, we must be able to detect profit manipulation. Before we learn how to detect profit manipulation, we first must learn how the accountants manipulate the profit numbers.
In Part 2, you will find how accountants cook their books. In Part 3, we will learn how to detect such manipulation.
Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
- Step 1 - Net profit and depreciation
- Step 2 - Net cash or debt movements
- Step 3 - Stocks add trade debtors less trade creditors
- Step 4 - Capital expenditure, goodwill, tax and dividends
- Step 5 - Other debtors and creditors
- Concluding Steps