One of the hardest parts when it comes to evaluating a company is its management. However, investors should not brush aside the importance of analysing a company’s leaders before investing in its shares. Here’s how Foolish investors can study a management’s competence and honesty when analysing companies.
Reading through annual reports
A company’s annual report is like a student’s report card. It contains things such as the letter to shareholders, the company’s financial statements, the pay packages of management, and the top shareholders of the company – these are sections of an annual report I play close attention when evaluating management.
When reading the letter to shareholders, which is usually written by the company chairman and/or chief executive officer, I’m looking out for candidness. Does the company’s management acknowledge mistakes that have happened, or do they sweep mistakes under the carpet?
I also check whether past-promises by the management team are delivered. If the company said that it would expand its business into a new country, for example, investors have to ensure that the promise is delivered. Reading at least five years’ worth of shareholders’ letters would be helpful in this regard.
Looking at insider ownership is useful too. If management owns a considerable stake in the company, it’s likely that management’s interests are aligned with that of the company’s other shareholders.
The annual report will also contain a section on management’s remuneration. If management helps itself to a growing pay package even when the company’s business performance is falling, it could be a major red flag. We can also cross-check management’s compensation with that of the company’s listed competitors.
What to look out for in the financial statement aspects of the annual report will be covered later.
Attending annual general meetings
Retail investors rarely get to see and talk to the management of a company, except during an annual general meeting (AGM). AGMs provide investors with a chance to get the know the leaders of a company and determine whether they are competent enough to be stewards of our capital.
During an AGM, we should observe the body language of the management when they speak. Is the management team forthcoming or do they mince their words? Are they professional in answering questions posed by shareholders? Do they talk down to minority shareholders?
After the AGM is over, management will usually be lingering around to chat with shareholders. Instead of rushing to the lunch spread, we can do further research on management by noticing how the managers and directors carry themselves when interacting with the visitors. Are they humble? Are they approachable and friendly? Are they interested in the concerns of their shareholders?
Looking at some financial ratios
The financial statement can also reveal the competence of a management team. Using the financial statement, investors can calculate three financial ratios to evaluate a company’s management. The ratios are: the return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC).
The ROE figure shows how efficient a company’s management is in turning every dollar of shareholders’ capital into net profit. As the ROE can be artificially increased through the use of excessive debt and share-buybacks, the ROA can be a better indication of a company’s profitability. ROA shows how profitable a company is relative to its total assets, regardless of whether the assets are financed by equity holders or debt holders, and reveals how efficient management is at using a company’s assets to generate earnings.
ROIC is usually considered as the best gauge of a company’s profitability. It tells investors how much money the company makes on all the capital employed, including both debt and equity. For a primer on ROIC, you can check out an article (follow this link) written by my Foolish colleague, Lawrence Nga.
If all three ratios are consistently increasing year-on-year, or stable at a high level, it could point to the presence of competent management.
The Foolish takeaway
Warren Buffett once said that when evaluating people, we have to look for three qualities: integrity, intelligence, and energy. He added that “if you don’t have the first, the other two will kill you”.
Evaluating the management of a company can be a daunting task. With the above tips and tricks, I hope investors can have a better understanding of how to evaluate the jockey behind the horse.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.