Hot Tip: Reading the Footnotes Can Tell You Way More Than EPS or ROE Ever Could
Believe it or not, the horse that finished 7th in the 2004 Kentucky Derby was giving out free investing advice.
The horse's name was Read the Footnotes. His owner was value-investing genius and hedge fund maestro Seth Klarman, CEO and co-founder of Baupost Group (the extremely successful hedge fund).
If you're going to take investing advice from someone, a hedge fund manager whose portfolio is worth billions is probably your best bet.
3 Things You'll Never Know if You Don't Read the Footnotes
If you've never indulged in the detailed drama that is financial statement footnotes, you're missing out. This article will highlight why those seemingly benign footnotes can be absolute game-changers.
The extent of business dealings with related parties
A related-party transaction is exactly what it sounds like — a transaction between businesses or individuals with a pre-existing business relationship or common interest.
All publicly traded companies must disclose the extent of related party transactions and their cumulative financial statement effect.
Imagine you're considering investing in a promising up-and-coming software developer. While flipping through the footnotes, you notice that one customer made up more than half of all sales revenue. And what's worse, the CEO's sister is the owner.
Would that change things?
Which financial statement numbers are guesses
Financial statement estimates aren't unusual or cause for concern. All companies use estimations; they're a normal accounting process and completely unavoidable.
Nevertheless, management estimates can have severe financial statement impacts.
Due to the inherent risk and subjectivity involved with estimates and projections, auditors spend a lot of time reviewing and evaluating the reasonableness of management's numbers.
What is concerning, though, is when financial statement users can't distinguish estimates from actual values. Fortunately, reading the footnotes can make it easy to figure out what's what.
When a company changes its accounting treatment for certain types of transactions
When new accounting standards are released, there is a transition period during which companies can choose when to adopt them.
These changes can have severe consequences on the financial statement. Sometimes, they also require restating financial statements from previous years.
The following excerpt from SEC Staff Accounting Bulletin Topic 11 discusses additional requirements for companies that choose to delay the adoption of a new standard.
Imagine a company's current-year profits are twice as much as last year's. Would it matter whether that was due to an accounting policy change and not the company's performance?
Absofreakinlutely.
Say you're thinking about investing in a hot, new biotech company. Their financials seem promising, with EPS and ROE in line with industry averages.
However, after reading the footnote on significant accounting policies, you learn that the company's reported profits will be cut in half once it adopts the new revenue recognition next year.
When you learn that 99% of companies in their industry have already adopted the new standard, EPS and ROE don't seem as impressive.
Their financials might've looked good at first glance, but knowing that their outdated accounting methods are inflating them puts things in an entirely different light — and it's not a good look.
Key Takeaways
Footnotes are among the most information-dense sources of corporate information. They may not be as "sexy" as EPS or ROE, but who said the financial analysis was supposed to be?
Hopefully, this article will help you better understand how footnotes can qualify and contextualize the amounts reported in a company's financial statements.
If nothing else, remember the next time a billionaire gives you investing advice, you might want to listen.
