How to Analyze an Annual Report (10-K) Like a Hedge Fund Analyst

legendary investor warren buffett has said in countless interviews that being able to analyze a company's annual report is foundational for successful investing in this video we are going to go over how to analyze a company's annual report also referred to as their 10k i'm going to use my experience as an investment analyst at a large investment firm to help you guys better understand what to look for as you go about analyzing an annual report whether you are a new investor just buying your first stock or whether you have been investing for years i guarantee if

you stick around till the end of this video you will learn something new and useful that you can begin applying to your own investment research process today a ton of work and research goes into making these videos for you guys so make sure to hit the like button and subscribe to the channel because it helps out a ton now let's get into the video for those of you who may not be as familiar an annual report also referred to as a 10k provides information about the operations of a company put simply the reason why an

annual report is so helpful is because it helps you better understand a business the trends that are affecting it and why it may or may not be an attractive investment i like 10ks because even if i know nothing about a company i can pick an annual report up read through it and then have a pretty good understanding of that company annual reports can run in the hundreds of pages for large complex companies don't be intimidated by that because as we go through this video i will let you know what you should be focusing on and

what you can skip over in this video we are going to go through apple's annual report to find the company's annual report just google the company's name and annual report so in this case apple annual report this usually brings you to what is referred to as a company's investor relations website this is where they put a ton of useful information and documents including the annual report once on the website scroll down until you see annual report or 10k once you see it click on it and it pulls up the annual report as you go through

the 10k you want to make sure you have a list of questions in your mind that you want answered questions such as how does this company make money how does this company sell its products or services how competitive is the industry the company operates in what risks is this company facing and what are the main metrics that i should track in order to evaluate this company i personally use a list of around 60 questions that i have developed in order to understand a company if you're interested in seeing the full list of questions that i

use you can view them through my patreon at the link in the description the first section of the annual report that i spend time on is the business section simply put this is where the company describes what it does what products or services it makes and really just how it makes money and my job whenever i'm given a new company that i'm not familiar with the absolute first thing i do is go to this section of the annual report here we can see apple describe its products which i'm sure most of us are familiar with

the iphone mac and ipad and then we can see here where they have this more broad category wearables home and accessories that consist of products like airpods apple tv apple watch and beats headphones among some other products the reason why this is so important is because this is where companies lay out the different segments of a business something i really like about apple is that they provide specific sales details for each of these product categories keep this in mind because we are going to revisit this later on in the video this means we can see

how sales are trending for iphones compared to the mac and ipad believe it or not a lot of companies don't actually provide sales information down to each specific product for us as investors the more detailed the better next up we have the services side of the business now this is a lesser well-known part of apple's business but it is growing rapidly here the company lays out the different ways it makes money through various services including advertising applecare cloud services digital content and payment services if you're unfamiliar with one of these the description underneath helps you

better understand what that particular service offering consists of so the main question we are answering by going through this section is how exactly this company makes money in the case of apple we see it's a combination of product sales and digital services the next section i like to look at is markets and distribution this tells us how the company distributes its products and who its main customers are in the case of apple we see their main customers are primarily consumers small midsize businesses education large businesses and governments additionally we can see that apple sells both

directly to customers through their own stores as well as through other companies such as verizon at t and retailers such as costco or best buy apple even goes as far as to say that direct sales channels think of the apple store and its website accounted for 36 percent of sales in 2021 while indirect sales accounted for the remaining 64 of sales the reason why this is important information to know is because let's say you are looking at a food company and 100 of their revenue is indirect through grocery stores what if one day those grocery

stores decide they don't want to carry that product anymore wouldn't that be very bad for your business these are the kinds of things you as an investor needs to know but real quick before we get into the next section i want to discuss an asset class that outpaced the s p 500 total return by 164 from 1995 to 2021 and is planning to grow from 1.7 billion dollars to a staggering 900 billion dollars by 2026. i'm talking about contemporary art this investment has historically only been reserved for the one percent of the one percent but

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want to better understand after reading through the section is one how competitive is this industry and two what are key variables that companies within this industry compete on so in the case of apple we see here that the markets for the company's products and services are highly competitive and are characterized by aggressive price competition additionally many of the company's competitors seek to compete primarily through aggressive pricing and very low cost structures and by imitating the company's products and infringing on its intellectual property so by reading this we see that apple's competitors try to compete mainly

on price in terms of what's most important to apple's continued success we see the company's ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products services and technologies to the marketplace also we see that some of the key variables companies in the industry compete with is price product and service features design innovation marketing and distribution capability and also corporate reputation as an investor these are all things that you need to know in order to invest successfully each industry has its different competitive dynamics we see here that apple depends

heavily on introducing new innovative products for the success of the company do you think that is true for a company like a railroad a mining company or a retailer not really this is why it's so important to understand the competitive dynamics specific to that particular industry because it very much depends on what company you are analyzing i want to jump ahead to what is referred to as the risk section of the annual report as an investor it's your job to balance both the positives of the company you're analyzing along with the negatives or risks of

the potential investment the risk section lays out some of the things that can negatively impact the particular business for apple let's take a look at what some of the main risks are for this company the company's business can be impacted by political events trade and other international disputes war terrorism natural disasters public health issues industrial accidents and other business interruptions global markets for the company's products and services are highly competitive and subject to rapid technological change and the company may be unable to compete effectively in these markets the company depends on component and product manufacturing

and logistical services provided by outsourcing partners many of which are located outside of the us okay just something important to note no matter how great a company is and trust me apple is one of the world's greatest companies there are always risks that you need to monitor these are risks that can negatively affect the business and as a result your investment however it's your job as an investor to see which of these risks really matter and which ones don't based upon your research next i want to jump ahead to the section titled management's discussion and

analysis of financial condition and results of operations based on that very descriptive title you could have probably assumed that this is where the company's management talks about how the business performed over the past year what went well and what maybe didn't go as well remember how earlier in the video we talked about the different segments of the business this is where the company provides revenue for each of those segments as well as discusses how each segment has been performing in this table we can see revenue for each segment over the past three years we can

see that each of the segments grew revenue pretty significantly over the past year the great part about this section is that management discusses what were the drivers behind the increase in revenue if you look at iphone management said iphone net sales increased during 2021 compared to 2020 due primarily to higher net sales from the company's new iphone models launched in the first quarter and fourth quarter of 2021 and a favorable mix of iphone sales and if we look at the services segment we can see that the increase in revenue was driven primarily by increased revenue

from advertising the app store and cloud services moving on to the next part of this section the discussion on gross margin if you aren't super familiar with the term gross margin you can check out the video i did on how to analyze an income statement like a hedge fund analyst here but put simply gross margin is calculated by taking the sales and subtracting out the cost directly associated with making that product this leaves you with what is referred to as gross profit to calculate gross margin you divide the gross profit by your sales numbers ideally

we as investors want to see gross margins expanding high gross margins is a sign that the company has what is referred to as pricing power or put another way they are able to charge a heck of a lot more for their products than what it cost them to make those products as we can see here apple's gross margins have been expanding each year over the past three years however notice that between 2019 and 2020 product gross margins actually decreased while total company gross margins increased slightly this is because services gross margin increased and the service

side of the business is growing faster than the product side remember how higher gross margins are better look at how much higher gross margins are in the services side of the business compared to the product side of the business gross margins and services is almost double that of products which essentially means that a dollar of revenue from the services side of the business is worth double to the company than what a dollar of revenue is from the product side no wonder apple's management is so focused on growing the surface side of the business this is

why it's so important for us as investors to understand the different components of gross margin if you were just looking at apple's financial statement where just had the company's total gross margin as opposed to this kind of detail you wouldn't have a full understanding but with this detail we have such a deeper understanding of the company we can see that in the future even if the company wasn't able to grow gross margins for products total gross margins for the company could still expand this is because the services is growing faster than the products and services

gross margin is twice that of products another area that affects the overall profitability of a company are operating expenses these are expenses that aren't directly associated with making a product or providing a service so think of things like marketing research and development sales the finance department things like that in order for a company to grow its profitability substantially revenue needs to be increasing faster than expenses this is a concept referred to as operating leverage which is where a company is able to grow its revenue while keeping many of its costs flat this is great for

you as an investor we can see here that total operating expenses for apple increased 13 from 2020 to 2021. that compares to revenue that grew 33 over the same period this is why apple has been able to continue to grow its profit even from an already extremely high base on the other hand if operating expenses were growing faster than revenue this is where the company's management could explain why that is happening maybe the company is going through a rapid growth phase where management is investing heavily in growing the business or maybe they don't have a

valid reason and it's just a poorly run company or an unprofitable business model those are all things you could learn from this part of the 10k and that leads us to the company's financial statements and related notes now this section could be an entire video in and of itself so i won't get into too many details we actually have done a whole set of videos on how to analyze the three major financial statements the income statement balance sheet and statement of cash flows like a hedge fund analyst and we have compiled those videos into a

playlist for you all to watch here now of course there's a ton of detail that is provided in the hundred plus pages that most annual reports are in length however the topics we covered in this video are the key areas you need to make sure you are focusing on throughout your research process i hope you found this video helpful make sure to like this video and subscribe to the investor center because i love using the knowledge i have gained to help make you a better investor talk to you soon