| How (and Why) to Read an Annual Report
This article appeared in the spring/summer 1998 issue of General American Solutions
for the life insurance policyholders of St. Louis-based General American Life
Insurance Company, and it is reprinted here with the permssion of General American.
Good, bad or indifferent, annual reports have one thing in common. They
are not news. Typically, the annual report appears about three months after publication of
a companys year-end results. By that time, anything unexpected or startling in the
final numbers will be picked clean of any significance as far as the stock market is
Why, then, should one pay attention to an annual report?
There is one very powerful answer to that question. If you approach the task of reading
annual reports in the right spirit, it will help you select great investments and avoid
Consider the nature of an annual report. Most companies go to considerable lengths to
cooperate with reporters and financial analysts who want to prepare in-depth reports on
their progress. The annual report is the only in-depth report over which the company, for
better or worse, has total control. It is the unfiltered truth, if not always the
unvarnished truth, from the company perspective. As Cecile Sorra, editor of Corporate
Annual Report Newsletter, notes, The annual report is the one chance a company has
to tell its own story without interruption.
An annual report bears the signature of the chairman and CEO and goes to everyone whose
opinion the company cares about: to every shareholder and to every stock analyst covering
the company, to employees, to news reporters, and to customers. In reading an annual
report, you therefore get an immediate sense of how well top management communicates, both
internally and externally. But that is only the beginning of what you learn, if you
exercise your critical faculties in the act of reading.
Given a chance to speak freely about themselves, companies, like people, will often
reveal more than they intend, disclosing certain flaws in their character... and they will
sometimes surprise you in a wholly positive way, demonstrating insight and strength that
you might never have suspected from the second-hand accounts rendered by newspapers,
magazines, stock market analysts, and brokers.
You can usually tell from reading an annual report whether the company in question is
daring to do great things, or whether it is already out to pasture. You also gain a
personal sense of the quality of the companys leadership and the clarity of its
vision and strategy. Ms. Sorra notes acutely, When annual report editors complain to
me about the difficulty of pulling together the information they need, I think it has a
lot to do with a lack of focus on the part of the people in top management.
The best annual reports take you inside the belly of the whale in a way that no outside
account of the company can duplicate. For example, I cannot remember a turnaround story in
Fortune, Forbes, or Business Week that is as compelling as the
one told in the 1995 Continental Airlines annual report. Continentals Gordon Bethune
began his 1995 letter to co-workers, customers, and shareholders with these
In January, 1995, our company faced tremendous challenges. For more than a decade
we had neglected the two vital requirements for any company to achieve long-term success
-- you must have a product you are proud of, and you must have employees who enjoy coming
to work every day. As a result, we were widely known as a last-place airline... As we told
you last year, our company couldnt be fixed with another deal or a visit to the
Bankruptcy Court judge. We simply needed to act like a real airline.
This dramatic opening was followed with a detailed account of the radical, yet
practical, actions that the airline was taking to boost morale, regain the faith of the
traveling public, and restore profitability. By the way, if you had purchased the
companys stock on the basis of reading the annual, you would have doubled your money
at todays stock price.
McDonnell Douglas Corporation (now merged with Boeing) is another company that used its
annual report both to recount and to reinforce a dramatic turnaround. In an article in the
June, 1995, issue, the Corporate Annual Report Newsletter was moved to comment: When
this defense contractor was almost flat on its back after the end of the Cold War,
producing little or no earnings, all we could see when we read its ARs was determination,
a direct and unflinching facing of facts, and a truly infectious optimism. If you read our
stories and acted on them by buying the stock, lucky you: the stock has tripled in two
years, during which McDonnell Douglas Corporation has provided higher combined annual
returns than any other aerospace company.
It is not just the companies in turnaround situations that invite and reward
readership. If you read the annual reports of Coca-Cola, General Electric, Berkshire
Hathaway, and Southwest Airlines, you get a powerful, first-hand impression of the factors
that have made them great companies... and why they have been able to achieve outstanding
results and great returns to their shareholders, year after year.
You might think that reliance on a single product -- even if it is the worlds
best-known brand -- would severely limit Coca-Colas horizons.
Plenty of analysts have thought so -- and have therefore missed out on a stock that has
created more value for shareholders over the past decade than any other. Perhaps they
werent paying enough attention to passages like this at the opening of the
late Roberto Goizuetas 1993 letter to shareholders: When people ask me about
the growth prospects of The Coca-Cola Company, I always respond with three simple facts.
First, every day, every single one of the worlds 5.6 billion people will get
thirsty. Second, only in the last few years have world events allowed us true access to
more than half of those people. And third, as the worlds foremost beverage company,
we are in the best position to satisfy their need for refreshment. We do not plan to
squander even a tiny portion of that remarkable potential.
A close reading of annual reports can also help in picking winners among emerging
growth companies. By definition, these are companies that do not have much of a track
record. If the combination of a great concept and great motivation is there, you should be
able to tell from the annual report.
Every annual report is a self-portrait. Look at them as such, and they will reward your
You will find some in which the subject appears uncertain, evasive, bombastic, or
simply dull. You will find others in which the subject appears deep seeing, knowing,
confident, filled with energy and purpose.
It all comes down to character. And character, as the saying goes, is
Varnished or unvarnished?
Truth is easy to impart when a companys business is surging with record growth and
financial gain for its stakeholders. The same applies to an annual report from a
non-profit enterprise if revenue during the year in question has met or exceeded goals.
But what if an organizations financial results that year werent so great?
Some companies in such circumstances will try to cast a ray of sunshine, or fog, if
necessary, on the awful truth.
How can the typical reader and prospective shareholder spot subterfuge?
By looking for clues:
Read the CEOs letter. Compare what he or she says or doesnt say about
earnings for the year with the published income statements. The audited numbers wont
Look at the selected financial data, consolidated balance sheets, and consolidated
statements of income. If the organizations revenues, operating income, net income,
and earnings per share for that year were up compared with the previous year, the numbers
will reveal that. If not, the numbers should reveal that, too.
If negative earnings are not addressed in the CEOs letter but a look at the
reports five-year income statement reveals an earnings decline be wary.
A section called managements discussion and analysis typically discusses
financial activities and conditions that contributed to the companys performance. It
may discuss how such activities are expected to affect the companys future. Look
here for insights about why, for example, sales in a division increased or decreased or
how the company dealt with interest expense.
Look for discussion of the companys historic record of dividends, assuming it
has one. A positive record of dividend distribution and growth is a good sign.
Does management offer a frank discussion of problems? The more candor, the better.