Few people will disagree that accounting is one of the least interesting parts of investing. However, an ability not only to read a balance sheet, but also to know which are the most important parts to focus on, is a vital skill for any serious investor. In his new book, former MoneyWeek writer Phil Oakley outlines some basic accounting checks that will help you get a better grip on a company’s finances.
First, Oakley suggests that you should look for companies that can deliver growing sales and profits as well as a high return on capital. The next step is to avoid what he considers to be dangerous companies – those with high levels of debt. Not only are these firms exposed to a downturn in business, but a clever accountant can also use debt to make a company appear more profitable than it really is. As well as traditional forms of borrowing, such as outstanding bonds or bank loans, investors need to be aware of hidden debts, such as pension obligations or long-term leases.
However, while growing profits and a strong balance sheet are necessary for a company to be worth considering, they are not sufficient. Even a profitable firm can be a bad investment if you end up paying too much for its shares, as many investors have found out the hard way.
So the final three chapters focus on the various valuation methods, beginning with the popular, but often misleading, price/earnings ratio (or earnings yield, as it is sometimes known). Oakley then looks at alternative measures of earnings, including free cash flow and cash profits, that may be less susceptible to earnings manipulation by management.
With such a technical topic, it’s hard to strike a balance between completeness and brevity. Provide too much detail and you risk drowning the reader in data, but provide too little and they could end up even more confused. The good news is that How to Pick Quality Shares gets the balance just right. Those intimidated by the prospect of carrying out mathematical calculations can rest easy since Oakley carefully walks the reader through the various steps, with worked examples. He also writes crisply and to the point, with the result that the book comes in at only around 200 pages.
This book isn’t something that you can dip in and out of, but you should be able to get through it in a few evenings. This makes it ideal for both those who want to improve their investing skills and as an introduction to the wider topic. I can’t think of any other book that makes looking at balance sheets seem almost interesting. As such, I strongly recommend it. This should be at the top of every investor’s reading list.