Get the Most Out of an Annual Report

The current market volatility is taking investors on a wild ride. Fear and panic are everywhere. But that same trepidation is leaving lot of businesses trading at attractive multiples. If you're a Foolish investor, you know that being greedy when others are fearful can lead to big profits. And a great way to find the market's best bargains is to start reading annual reports.

Get out your reading glasses
In a recent interview, Warren Buffett quipped, "Some men read Playboy. I read annual reports." He isn't kidding. He reads annual reports all the time. He probably plows through thousands of them a year. And why shouldn't he? After all, you can learn more about business and investing from those reports than you can in most business-school classrooms. Even if you work through a report and decide that the business isn't for you, you've still started building a mental model of the business world and the various industries within it.

Speaking of Buffett, every single person even remotely interested in investing has to check out Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual report. It's a must-read.

What to look for
Some annual reports are pretty, color-filled documents that, although helpful, function more as a marketing and communications tool than anything else. What you really want to dig into is the annual 10-K, the boring (and, at times, long) black-and-white document containing the information that public companies must file with the SEC. Knowing the difference is important, because a lot of the larger companies, including ExxonMobil (NYSE: XOM  ) , produce annual reports separate from their 10-Ks.

The 10-Ks begin with a detailed description of the business, followed by risk factors, a rundown of any legal issues, and, finally, the numbers and financial notes in the back. The best stuff is usually at the end, and it may take you a while to get there. The bigger the company or more complex its operations, the longer and more complex the annual filing is. Citigroup's (NYSE: C  ) 2006 10-K came in at 180 pages! So before you invest, you'd want to understand what's going on in this document.

A basic primer
People read annual reports in different ways. I've met some investors who prefer to start at the back and work their way to the beginning. It makes no difference how you read them, as long you absorb the essential points of the business.

Without question, you should read Item 1, which is the business description. You can't possibly go any further in your research without knowing what the company does! Most business descriptions are repeated in abbreviated form in other sections of the report, but that doesn't mean you should skip Item 1.

After that, you should proceed to Item 6, which is usually a page or two of summary financial statements, followed by a more detailed and quite lengthy synopsis of the financials, including the notes to the financial statements. These notes are extremely important. If you're still interested in the business by the time you get to them, examine them very meticulously.

Once you've gotten this far, you should then go back and read the Risk Factors section, which comes immediately after the business description at the beginning. By law, these risk factors must disclose everything about the business. So you might read something that doesn't seem to mean a lot, like "our stock has historically experienced volatility and can decline substantially." That's OK. It should be of no concern to you, if you understand the business. But if you don't understand the business and its operations, you might not be able to put the comments in this section in their proper context.

Do what comes naturally
We all have different ways of deciphering and storing information. Read the annual reports in the way you see fit. If the market's volatility is keeping you on the sidelines, at least you can arm yourself with as much industry- and company-specific information as possible. That way, when the time feels right, you'll be a fully informed investor.

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