By Narendra Nathan
People who invest on the basis of tips are investing blindly. But even investors who study the fundamentals of companies before buying stocks usually restrict the research to basic details such as revenues, net profit, earnings per share (EPS) and price to earnings ratio (PE ratio). This information is available in the quarterly numbers declared by companies, so most investors don’t feel it necessary to read the bulky annual report that comes once in a year. However, experts say that reading annual reports is necessary because they contain a lot of information that is not available otherwise. “Reading annual reports becomes an advantage because very few people do it,” says Nilesh Shah, Managing Director, Kotak Mahindra Mutual Fund.
Read it in full
The annual report is a bulky document, sometimes running into 180-200 pages. Experts say one should read the full document. “Investors should go through each line of the annual report,” says Daljeet S. Kohli, Director & Head of Research, India Nivesh Securities. To begin with, focus on the first part of the report. “Most companies give financial highlights of the past 10 years. While these numbers may not be of much use to institutional investors, they are useful for retail investors to understand how the company has grown in the past,” says Anand Shah, Deputy CEO & CIO, BNP Paribas Mutual Fund. “Read the notice because it gives lot of information and sets the agenda of the annual general meeting. Investors should also read the chairman’s speech that gives a clear vision about the future and the directors’ report (along with management discussion and analysis) which explains current business structure before going to the net profit figure,,” says Deven Choksey, Managing Director, KR Choksey Securities.
Other experts also highlight the importance of the management discussion. “The management discussion tells where the company is headed in future,” says Kunj Bansal, Executive Director & CIO, Centrum Capital. “Management commentary is very important because they usually talk about plans for the next 3-5 years,” says Anand Shah of BNP Paribas Mutual Fund. Investors should also read notes to accounts, schedules, cash flow statements, etc also because they give information in more detail.
Companies with large cash flows
A large cash flow from operating activities is a healthy sign and shows that all is well with the company
Investors should question if the profit is not supported by cash from operations.
Deciphering the numbers
Investors also need to understand the difference between what the company says and what it means. “While some companies tell outright lies, others tell truths that are convenient to them. Since no company is going to tell the whole truth, you should be able to read between lines,” says Nilesh Shah. However, the average investor may find it difficult to read an annual report in detail and understand it in its entirety. Here are a few key points that an investor needs to look at.
Continuity is key
Continuity is an important parameter. Compare each figure with that of the previous years to get an idea of how the company has done. “If any figure is significantly higher or lower than that of previous years, investors need to delve deeper. Don’t assume that something is wrong, but certainly check the the reasons behind this deviation,” says Kohli. “There should also be continuity and coherence between all parts of annual reports. For example, the numbers in the other parts of the annual report should match those mentioned in the chairman’s speech or directors’ report,” says Nilesh Shah. There can be instances where the management says the industry and the company are doing well, but the company has reported lacklustre revenue and net profit growth. Similarly, management might have talked about the successful capacity addition, but the same is not reflected in the sales volume. If there is a deviation, you need to understand the reasons behind it.
Is the sales real?
Companies declare sales figures in their quarterly results. But are these sales real? Several sales based ratios (market cap to revenues) are used for valuations. The first check is to add up sales of the four quarters to see if they match the annual sales figure. Checking sales growth with that of increase in debt is another way. “If the debt is also rising with the sales, it may mean the company is buying sales (giving away goods without bothering to collect money,” says Bansal of Centrum Capital. Also check the notes of account to make sure that the company follows conservative accounting policies. This is especially true when you deal with real estate companies which are allowed to have more flexible revenue recognition rules. “It is better if real estate companies recognise revenues after completing the project. But most companies follow percentage completion method to smoothen out sales and net profit,” says Viraj Mehta, Head & Fund Manager, Equirus PMS. When you compare the sales figures of two real estate companies, make sure that you are making an apple to apple comparison.
Is the profit real?
Just like sales, you also need to cross check the net profit figure because price to earnings (PE) ratio is the most commonly used valuation tool. Companies manipulate the profit figure by providing for excessive (or even less) depreciation. While quarterly numbers give just a consolidated figure, annual reports give a detailed breakup of the depreciation provided for each asset. The depreciation provided should be reasonable. Be alert if there is a sudden increase or decrease in the depreciation figure. “If a company is providing 10 years of depreciation for computers, it is a clear case of inflating the profit,” says Nilesh Shah. Research and development (R&D) expenses is another head that needs close verification. “Ideally, the R&D expenses should be written off in that financial year itself. However, companies usually capitalise it and then write it off over a period of time. It’s a red flag if the write off period is more than four years,” says Mehta of Equirus. Capitalising interest (instead of showing it as expense, it is added to the cost of project) is another strategy used by companies. Some even capitalise the mark to market losses on forex positions on loans taken for buying assets and usually add this loss to the loans. Another trick to inflate profit is by avoiding the profit and loss account altogether and taking expenses directly to the balance sheet. “Investors should raise a red flag if companies deduct some big expenses directly from the reserves, instead of showing it in profit and loss account,” says Jaspreet Singh Arora, Senior Vice-President, Systematix Shares & Stocks.
The relationship between the profit declared and the tax paid can also generate some hints about the quality of profits. “Investors need to verify whether the company has paid proper tax after declaring high profit,” says Nilesh Shah. Here again, don’t assume wrongdoing by companies because it may be because of some tax incentives given by the government. For example, infrastructure major Adani Ports enjoys several tax benefits. Indian law allows companies to have separate books for investors and for income tax department and that is another reason for this anomaly.
Companies with low tax outgo as % of profit
A low tax outgo is not always a sign of something amiss. The company may be eligible for certain tax breaks offered by the government to some sectors.
Investors should question if the tax paid is not in sync with its net profit.
Should companies provide for the disputed demands such as excise duty, sales tax, income tax and water tax or show them only as contingent liabilities? Most companies take the conservative view and provide now and show as gain in year if the verdict comes in their favour. However, there are also cases where the companies decide to keep these as contingent liabilities till the final verdict is verdict is out. The Orient Paper annual report for 2015-16 shows an accumulated contingent liability of Rs 206.57 crore as against its cash and bank balance of Rs 59.15 crore and net profit of Rs 21.35 crore for the year.
Companies use Employee Stock Option Plan (ESOP) to motivate the employees to perform better and improve shareholders’ value. While ESOP creates a sense of belonging and ownership amongst the employees, it can create computation of net profit difficult. Companies in India usually use ‘intrinsic value method’ for determining the cost of ESOP. For example, if a company grants right to buy shares at Rs 100 after 3 years against the current market price of Rs 150, the cost of that ESOP is treated as Rs 50 (Rs 150 minus Rs 100). The ‘fair value method’, on the other hand, uses advanced option pricing models like Black-Scholes model and takes into account the various other factors like time value, interest rate, volatility, dividend yield etc.
Since these two computations are different, the impact on net profit can be significant. This detail will be given in the ‘Notes to Accounts’ section. Investors must consider outstanding ESOPs while computing earnings per share (EPS). While EPS is computed normally with the existing outstanding number of shares, one needs to consider the outstanding ESOPs (ie which will become shares in future) also for correct computation. Companies provide these details (total number of shares, including ESOPs, for computing diluted EPS) in their annual reports.
Companies with large revaluation reserve
Since valuation tools use the company’s net worth as the denominator, make sure that the value given out in the balance sheet is a fair one.
Investors should remove revaluation reserve and goodwill while computing net worth.
Cash is king
As the old idiom says, ‘revenue is vanity, profit is sanity and cash is reality’. Since cash is king, cross check the net profit with that of cash generated. Since Sebi has made cash flow statement mandatory for listed companies, this information is readily available in the annual report. “If there is no cash flow behind profit, the company will get trouble in the future,” says Anand Shah. The best way here is to compare the net profit with that of cash from operations (see the list of BSE 100 companies with large cash from operations). Analysts now closely track a parameter called free cash flow (FCF). It is computed by bringing in capital expenditure (such as investments in buildings or property, plant and equipment, etc) also (ie free cash flow = operating cash flow – capital expenditures). While free cash flow is good, be careful when be careful when it comes to companies generating very high free cash flow and not distributing the same to shareholders through higher dividends or share buybacks. “Most differ foreign companies with high FCF use it to pay dividends or buy back, but that is not frequent in India. Independent directors should add more value in this,” says A. Balasubrahmanian, CEO, Birla Mutual Fund.
Similarly, companies with negative FCF are not bad either. They may be in the initial phase of growth (ie setting up large plants for future growth). So, don’t assume that something is wrong if there is a big divergence between profit and cash generation and as mentioned earlier, investors need to question and understand the difference between profit and cash flow.
Is the net worth real?
Since several valuation tools like price to book (PB) ratio use the company’s net worth as the denominator, investors should make sure that the value given out in the balance sheet is a fair one. “Ideally, reserves should be built from accumulated profits. But some companies have the habit of inflating the reserves by revaluing the assets. So investors should avoid revaluation reserves while computing net worth,” says Balasubrahmanian.Goodwill is another asset that gets into the books due to mergers and acquisition activity (see table for BSE 100 companies with large revaluation reserves + goodwill).
Here again, this is allowed by the law, but investors need to look at the true future potential of the company and a large balance sheet size due to revaluation doesn’t generate that confidence. Companies try to show balance sheet strength by not providing some possible liabilities. For example, the balance sheet of of PSU banks will look totally different if all the non performing assets (NPAs) were written off. Similarly, the balance sheet of most PSUs will shrink significantly if one accounts for the possible pension liability in future.
Related party transactions
Most Indian companies are family owned. Investors must scan annual reports for any related party transactions, which may be in conflict with the interest of minority shareholders. There are several cases of related party transactions like goods sold or bought from entities owned by directors, subsidiary borrowing and giving it to parent or vice versa, etc. The recent proposal for transfer of JK House to family members of Raymond promoters was mentioned in the notes to accounts of the company’s annual report. The proposal, which sought to transfer apartments at 10% of the prevailing market price, came up for voting at the AGM on 5 June. The promoters, being interested parties, abstained from voting on this matter and shareholders voted against the resolution. If approved by shareholders, the loss to the company could have been around Rs 650 crore.
Raymond’s annual report had mentioned the proposal to sell JK House to family members of the promoters. Investors should watch out for such red flags.
Commenting on the development, Gautam Hari Singhania, Chairman and Managing Director said, “I am happy with the outcome of voting against the resolution as this decision by shareholders is in the best interest of the company and shareholders and is aligned to my personal opinion on this issue expressed earlier. Protecting shareholders interest is of paramount importance to me.”
Though things ended happily at the AGM, experts are not amused. “Not able to understand the logic of the chairman’s action He first proposed the land sale for shareholders’ approval and then welcomed the voting down of the same by shareholders. If the same was against investor interest, this proposal should have been rejected at the board meet itself,” says a Mumbai based mutual fund manager.
Management salary
“Investors need to watch out for the management remuneration. It is a red flag if the remuneration is very high,” says Mehta of Equirus PMS.
Recently, Infosys co-founders have raised the issue of high salaries to some management personnel because they had access to the information. However, retail investors need to wait till the arrival of annual report to get this information. There is nothing wrong if the top management is paid according to market rates. However, investors need to be worried if the top management is extracting significant funds in the form of salary and commissions. Since the Companies Act restricts total remuneration of management personal to 10%, investors can use any payment above 5% as the red flag. Balakrishna Industries is a good case of it crossing this 5% mark.
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