Evaluating annual reports.

How to separate fact from fluff

A man's best friend is his dog, but the investor's best buddy is the annual report. By reviewing that piece of literature, you can unearth a company's profitability, standards and management team.

A company uses its annual report to deliver mandatory and voluntary information to shareholders and potential investors, as well as give an accurate picture of the company's performance over a period of time. If comprehensive, it can provide you with a window into the company's future.

The annual report is perhaps the most important document that companies produce for shareholders, says Kenneth Janke, president and CEO of the board of trustees of the National Association of Investors Corp. (NAIC), the Madison Heights, Michigan-based trade group representing some 37,000 investment clubs. "It's a vital tool in analyzing companies whose securities investors wish to buy, hold or sell," he adds.

Over the past 10 years, the NAIC has given kudos to corporations with the best annual reports. The Nicholson Awards--named after George Nicholson, one of the organization's founders--are intended to help corporations improve the way they disseminate investment information and make annual reports more reader-friendly. Companies go through a rating process in which forms are returned to participating corporations with comments from judges.

Last year, investment club members evaluated more than 800 company reports. Here's how the documents are rated: Companies are identified by industry--97 industries in total are represented, although not every industry may have a winner. If there is a sufficient number of entries in a particular industry, the awards are further divided according to company size--from small caps to large companies. "We think it's unfair for a company that has revenues under $100 million to have to compete with an IBM, [which has] billions of dollars in revenues," says Janke. "The smaller guys can't afford to spend the same kind of money preparing their annual reports."

Judges read the reports from cover to cover and award points for various types of information and content. In general, an annual report is divided into five sections: the CEO's letter to shareholders, business segment information, management's discussion and analysis, financial statements and footnotes.

"We instruct our judges not to judge the company but just the report itself," explains Janke. "We aren't saying whether a company is a good or bad investment. We are trying to find out if the information is there to help you make an [educated] investment decision." Specifically, judges examine financial highlights, historical financial information, management discussion, other narrative comments, and report design and readability.

"We are really looking to see if the companies are candid in their reporting," adds Janke. "Are they overly optimistic or are they talking about real problems as well as all of the successes they have had or expect?"

First, the CEO's letter should spell out the company's past performance and its future prospects. How does last year's letter compare to this year's facts? Does management talk about increases or cutbacks in product lines, inventory, manufacturing plants, personnel and programs? Do footnotes contain more detailed information about company operations? Do the photos and charts supplement the written report, or are they extraneous?

Janke says annual reports are much more forthright today than they were a decade ago, especially in providing complete financial information. The financial statements should examine the company's assets and liabilities, stockholders' equity, long-term debt, net earnings and net revenues. "Basically we look for fundamental information about earnings and pretax profit margins and a compounded growth rate," he adds.

Investors should review a company's annual report each year to assess the company's progress, especially as it relates to revenues and earnings per share. For example, find out if a given company's earnings represent a percentage of investment capital.

However, don't use the annual report as the only barometer on which to base investment decisions. Use advisory services and read analysts' reports in such publications as Value Line and Standard & Poor's The Outlook. For the most part, the annual report gives the investor a feel for the company's management. It's essentially his or her chance to see what's on the mind of the CFO or CEO.