As I mentioned in my earlier post The Best Kept Secret to Successful Investing, the most important rule to remember in investing is never lose money.
In The Intelligent Investor, Benjamin Graham introduced the concept of “margin of safety". Buffett calls “margin of safety" the three most important words in investing. The concept is simple. But before I get to that, an understanding of the difference between price and value is crucial.
The underlying value of a company is not always reflected in the stock price. The true value of a business is what's known as the intrinsic value. Buffett couldn't have summarized it better, “Price is what you pay, value is what you get. "
Because no one, not even Buffett, can determine the exact intrinsic value of a business, it would be wise to allow some margin for errors in our assumptions. This margin is what Ben Graham calls margin of safety. Graham and Buffett both advocated allocating at least a 40% margin of safety.
The above concept is best illustrated with an example. Assuming you valued Tom's Great Company at $10/share, you are not to buy until the price drops to $6/share. What this translates to is if your assumptions were wrong, and the company turned out to be worth $6/share, you would still be getting your money's worth. You didn't make any profit, but you didn't lose any capital either. Put another way, even if the company loses 40% of its value, you might still haven't lost any money. Clearly, this lends itself pretty well to never losing money.
However, there is one assumption that could throw all your assumptions off course, even with a wide margin of safety - fraudulent accounting. With the SEC and auditors watching the financial reporting like hawks, it is only reasonable for us to expect that the statements are a fair representation of the business. Unfortunately, having lived through the Enron and Worldcom debacles no one dare vouch for the truth anymore. After all, Arthur Andersen, one of the world's largest accounting firm that promptly went bankrupt, knew about Enron's fraudulent accounting all along. How can we as individual investors, without the help of an army of competent accountants, detect even the slightest signs of fraudulent accounting?
Well, it's safe to say it's very difficult. But it's not impossible. There are some simple tests that we can apply to help us identify some form of potential deceptive accounting. I must preface with the following. . . Like everything else in investing, never rely on a single factor to make a decision.
One of the most common chicanery in accounting is inflating revenues. Revenue, as the first line item in an income statement, is quite important. Comparison of past period revenues tells whether the company is growing or stagnant at a glance. Growing revenues also paints a pretty picture that can sometimes distract investors from the weaker aspects of the business.
According to the Generally Accepted Accounting Principles (GAAP), revenue should be recorded once the product has been delivered or, in the case of a service company, the service has been rendered. In other words, the customer is now obliged to pay.
In double-entry bookkeeping, a sale of merchandise is recorded in the general journal as a debit to cash or accounts receivable and a credit to the sales account.  In laymen terms, you should see an increase in cash or money owed to you when you make a sale.
A sale, as it is normally intended, would result in higher net income and therefore higher operating cash flow. But when revenues are inflated, there is usually not enough cash to back up the revenue growth. You can pump up the numbers, but you still won't get the money out of thin air. The money has to come from somewhere. In an honest-to-God operation, the cash would have come from your customers. But if the sales were only on paper, you will have to get pretty creative to come up with the cash.
Hence, one of the first things to look for in identifying potential inflated revenue is the operating cash flow to net income ratio. Here's an illustration for Tom's Great Company:
Tom's Great Company Operating Cash Flow and Net Income
2004 2005 2006 2007 2008
Revenue (millions) 1340 1507 1567 1683 1714
Cash Flow From Operations (CFFO) (millions) 52 45 67 34 18
Net Income (NI) (millions) 133 145 153 166 178
CFFO / NI 0.39 0.31 0.43 0.20 0.10
A significant drop of CFFO to net income ratio indicates a possible accounting trick. Also, be careful when CFFO materially lags behind net income.  This means sales are not converted into cash as fast as sales growth. Since the business needs to spend more cash to generate higher sales but it's not getting more cash coming back in, eventually it will face a cash flow shortage leading to potential bankruptcy. Now, management may be able to cook up some pretty good explanation for this. But it is a warning sign to clear up before you invest in the company.
Of course, with a contrived example, I can even prove I am Superman. In reality, as we have witnessed in Adelphia, management could go above and beyond to cook up the books. “In looking for someone to hire, you look for three qualities: integrity, intelligence and energy, " said Buffett. “But the most important is integrity, because if they don't have that, the other two qualities, intelligence and energy, are going to kill you. "
- Pinson, Linda and Jerry Jinnett. Keeping the Books, Second Edition Upstart Publishing Company, Inc. , 1993. p. 15.
- Howard Mark Schilit. Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports, Second Edition, McGraw-Hill Professional, 2002. p. 67
I'm Ye, a Principal of Qovax . Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog .