I think that most investors can agree that performing careful due diligence on an investment is a necessity. What investors cannot seem to agree on, though, is what constitutes “due diligence.”

The Devil Is In the Details

Real due diligence must include analyzing every page of a company’s annual report or 10-K filing. These filings provide the only complete report of financial data on a company. Not studying every detail in these reports before making an investment is like driving your car at night without headlights. You might get lucky and not have an accident — or you might total your car.

The challenge here is that great amounts of time and expertise are required to analyze an annual report from cover to cover. These reports have become increasingly long and complex (see details in Justin Lahart’s Wall Street Journal article from earlier this year). Adding to the challenge is that most of the length and complexity is not in the financial statements with which more people are familiar. It is in the financial footnotes and Management Discussion & Analysis (“MD&A”). We will refer to both as “footnotes” for the rest of this report.

Any assumptions that data in the “footnotes” is less important are false. On the contrary, some of the most crucial financial data is contained in the footnotes. We’ve written reports on over 30 items from footnotes that dramatically distort a company’s reported profitability. Quite often, footnotes reveal issues that can totally change one’s investment opinion.

Dangers Lurking in the Footnotes

Over the past 15 years, we have analyzed footnotes from over 75,000 annual reports. We have developedsystems and databases to augment our analytical processes and help us find more critical data.

A quick and dirty way to see the impact of certain footnotes adjustments is to look at their effect on the most popular reported result: net income.

A company’s net income under GAAP requires it to include many charges and income that have no bearing on the firm’s operating profitability.

We remove unusual items from net income to measure net operating profit after tax (NOPAT). NOPAT gives investors a better idea of the after-tax cash flows they can expect from the company going forward.

Often, NOPAT diverges significantly from net income. Figure 1 shows the five Dangerous-rated stocks in the S&P 500 with the most overstated net incomes in 2013 as a result of items found only in the footnotes.

Figure 1: Dangerous Stocks With The Most Overstated 2013 Net Income

Sources: New Constructs, LLC and company filings.

In the cases of Hess Corp. (HES), Zions Bancorp (ZION) and Murphy Oil (MUR), our calculation of operating profit reversed rising trends in profitability. While these companies’ net incomes increased year over year, their NOPATs actually declined.
Sources: New Constructs, LLC and company filings.

Uncovering Hidden Gems

Footnotes can reveal good things too. For example, unusual expenses bundled into the income statement line items can artificially lower net income. When these unusual expenses are removed from net income, operating profitability can be much higher than reported results suggest.

Figure 2 shows five Attractive-rated stocks that had the most understated net income as compared to NOPAT in 2013 as a result of items found only in the footnotes.

Figure 2: Attractive Companies With The Most Understated 2013 Net Income Due To Footnote Items

Sources: New Constructs, LLC and company filings.

The differences between net income and NOPAT as seen in Figure 2 are large, but not uncommon. In addition to the companies in Figure 2, 13 companies in the S&P 500 reported losses in 2013 but earned positive NOPATs thanks to unusual items found only in the footnotes. These companies include Alcoa (AA), CenturyLink (CTL), and Devon Energy (DVN).

According to its reported profits, Alcoa earned a GAAP loss of $2.3 billion in 2013, down from its 2012 reported profits of $189 million. However, Alcoa’s 2013 NOPAT was $841 million, up 24% over its 2012 NOPAT. This discrepancy was due in part to $460 million in hidden restructuring expenses buried in the footnotes. The stock is up over 55% this year.

Proper Due Diligence

To be successful in today’s markets, investors need to gather all the facts and focus on the right metrics.

Lots of research firms talk about NOPAT, ROIC, cash flow, “EVA” and economic earnings. Very few firms take the time or have the expertise to gather the necessary information from footnotes to derive these metrics correctly. Models are only as good as their inputs. Put garbage data in and you will get garbage results.

As a firm, we studied footnotes for decades. We have developed proprietary technology to analyze footnotes and build our own database of financial data. We did that work to ensure we have the best data and best models for measuring cash flow and valuation in the business because we believe diligence matters.

And footnotes matter because they are the only source for data that is necessary to calculate operating profitability accurately.