Saturday, October 15, 2011

Quality of Earnings: Chapter 3

Investors rely heavily on the financials that companies release. But managements have significant leeway when it comes to creating its results. In this book, Thornton O'Glove tells investors how to judge the quality of a company's earnings, in order to both protect against fraud and find value.

The annual report is the first place to start when researching a company. If you read the annual report, you are already ahead of the game, as research suggests half of a company's investors don't do this much.

Many companies put a lot of effort into presenting their annual reports, at great costs to shareholders. You'll find many reports with glossy photographs printed on expensive paper, but you'll want to get to the meat of what the company is about right away. The first "meaty" portion of the annual report that you will encounter is the letter to shareholders.

O'Glove spends this chapter telling readers what to look for in the shareholder letter. First, verify what is being stated by the Chairman or CEO in the letter, by referring to the financials. Second, if management is making forecasts, go back and look at their previous letters to see if their forecasts were worth their salt. Finally, look for candor. You don't just want upbeat, optimistic statements; instead, you want the company's challenges and problems discussed, with management's plan for tackling these issues.

To provide examples, O'Glove reproduces the entire actual shareholder letter of one company and tears it apart. He also reproduces portions of other company letters and discusses what's wrong with them, or in some cases, what's right with them.

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