Warren Buffett: How To Read An Annual Report

0:00 I like to know as much as I can about the person that's running it and how they think about the business and what's really going on the business. And I would like to have a report that would be identical uh to what if I owned half of a company but was away for a year and I had a partner who owned the other half what when I came back that he would tell me about what had taken place during the past year and what he foresaw coming up.

0:22 >> That's Warren Buffett explaining why reading annual reports is essential to good investing. But Buffett said that most investors don't read annual reports, which is a massive mistake. Hey, I'm Brian Faraldi. I'm a financial educator that's been studying Buffett for more than 20 years, and I've read hundreds of annual reports myself. In this video, I'll show you exactly what Warren Buffett looks for when he's reading annual reports, and where to find the key information using his investing checklist as a guide. At the end of this video, you'll be able to analyze an annual report the same way that Buffett does. So, here's Warren Buffett's investing checklist. Notice that it's broken out into three main sections. First is the business section.

1:00 Second is the management section. And third is the financial section. Reading an annual report can help us to find 90% of the information that we need to fill in this checklist. So let's run through this checklist using Moody's annual report as an example, which is one of Buffett's favorite companies of all time. Now after pulling up the annual report, the first thing we need to do is to scroll down to the index section. Then we're going to go to item one, the business overview, and read everything about the company. Now, while reading, Buffett wants to make sure he understands exactly how the company works. Buffett asks himself questions like, "Is this business understandable?

1:37 How is the money made? Does the company have good long-term growth prospects? And is there a big moat around the business?" The answers to these questions should be obvious and explained in plain English. Now, after we've read the business sect, we can actually fill in about onethird of Warren Buffett's investing checklist. If Buffett can't easily answer all of these basic questions, Buffett has no problem immediately putting that company into his two hard pile, which is actually a real thing, and he simply moves on to the next idea. Uh, by the way, if you want a free copy of Warren Buffett's checklist that I'm going to be using throughout this video, just visit longtermmindset.co/buffett or click the link in the video description. Now, next, Buffett jumps to section 1A or the risk factor section of the annual report. This is a long list of everything that could possibly go wrong with the business. Now, Buffett keeps an eye out for key risks like revenue concentration, pricing risks, regulatory risk, and risk related to competition. Now, Buffett doesn't avoid all risk. He's just making sure he understands all of the risk that he would be assuming as a potential shareholder and owner of the business.

2:42 Now, after reading the risk section, we can fill in even more of Buffett's investing checklist. Now, step three is to read the company's letter to shareholders. Now, while this is technically not part of the 10K, and many companies do not have a shareholder letter, those that do offer pure gold. Now, Moody's just so happens to have not one but two shareholder letters. One is from the chairman of the board and one is from the CEO. Now, as Buffett's reading through these letters, he's looking for signs of honesty, clarity, and accountability from whoever wrote the letter. If the CEO sounds like a politician or an overpromotional salesman, that's a big red flag, and he moves on. But now, we can have even more of Buffett's investing checklist filled in. Now, step four is to read item seven, which is called management's discussion analysis of financial conditions and results of operations, or simply MDNA in its entirety. This is where the management team explains not only what is happening with the business, but why things are happening.

3:40 And Buffett reads this section like a detective and he wants to know, does the company have a consistent operating history? Are they owning the results or are they blaming outside forces? Are they long-term thinkers and planners or are they more short-term focused? Reading the MDNA section in its entirety can help Buffett answer these questions and get a far better feel for how management thinks and runs the business. After reading the MDNA section, we have much more of our checklist filled in.

4:06 Now, the next step is to move on to item number eight, which shows the company's financial statements. This includes the company's income statement, balance sheet, and cash flow statement. Now, Buffett examines all three of these statements very closely, looking at revenue, margins, profits, cash, debt, and cash flow. Importantly, he also reads all of the footnote sections which can reveal details related to accounting tricks, lawsuits, leases, and all the stuff that gets buried in the annual report. Now, importantly, Buffett's not looking at just one year of data. He's actually hunting for trends. By looking at trends, he can learn if a company has pricing power, good returns on equity, and low capital needs. Now, unfortunately, this is where annual reports can fall short. See, annual reports typically only show two to three years worth of data. That's why I prefer to check the numbers of a company using fiscal.ai, which allows me to view 10 plus years of financial data and have all the financial ratio analysis done for me as well. Plus, I can click on any number and see a chart of how that number has changed over time, which makes it really easy to detect long-term trends. And now we have even more of Warren Buffett's checklist filled in.

5:17 Now, the next step is to judge the quality of the management team. Now, by this point, Buffett has already started to form an opinion about management for what he's read so far by looking for signs of cander, clear thinking, and a long-term focus. But now, he goes back to the Andrew report and he looks at items 10, 11, and 12 to find more information about management's background, executive compensation, and stock ownership information. But here's the catch. Most of what Buffett wants to know about the management team usually isn't found in the annual report.

5:47 Instead, the annual report usually points to a company's proxy statement, which is a separate document that details executive pay, stock compensation, and ownership. And that's where Buffett digs in. He looks for compensation structures that reward long-term performance, not just short-term stock bumps. Whether stockbased compensation is properly expensed, which is a topic he's been outspoken on for years, and how much skin in the game management has. He prefers to invest in leaders who are significant shareholders. Buffett uses this information to answer questions like, "Do they treat shareholders like partners? Are their interests aligned with ours? And are they rational, disciplined capital allocators?" Buffett from the belie that answering these questions one of the most overlooked parts of company analysis and yet also one of the most revealing. Once we have that information done, we are nearly done filling in Buffett's checklist.

6:33 Now, that brings us to the final step of Buffett's analysis, which is to do all that analysis again, but this time looking at the company's competitors. Buffett insists that reading the reports of all the company's biggest competitors allows you to learn as much about the industry as you possibly can. And sometimes by reading the reports of competitors, Buffett realized that another company in the industry is actually the better investment. And by reading those reports, Buffett gets a better sense of how margins are shaken out, market share, and what trends are happening in the industry in general. So in Moody's case, we would check out the annual reports of companies like S&P Global, which is a major competitor to the company. Now once we've read the reports of the major competitors, we can finally check off the lax box on Buffett's investing checklist. Now once Buffett understands the business and trusts the management team, he now asks one final question. What would I pay to own the entire company? He builds a rough estimate of intrinsic value based on the company's future cash flows. And then he compares that intrinsic value to the current market price. If the stock is trading below what he thinks the whole business is worth, he's interested. And if there's a wide gap, he might even buy. If the current market price is above his intrinsic value, Buffett has no problem putting that company on his watch list and waiting for a better opportunity. Well, thanks for watching this video. I hope you enjoyed it. And if you want a free copy of Warren Buffett's checklist, just visit long-termmindset.co/buffet and I'll email you a free copy. If you like this video, give it the thumbs up.

7:56 It really helps us out on YouTube. And if you want to keep learning for free, there's a 100% chance you'll enjoy watching this video next.