Anybody who reads financial statements without a calculator in hand, or a spreadsheet open, is missing a trick. You don't need to build a huge financial model and forecast ten years into the future to get value out of it. But I think you do need at least two, preferably three or four years' reports, and a good dose of pragmatism. This isn't about working out the 'right' number in the way accounting students do, with multiple adjustments - it's more about getting a good feel for the trends.
Margins
First off, I never, ever read a results statement without calculating the operating margins and, if I'm looking at a retailer or reseller, the gross margins. If you have a revenue growth story with declining operating margins - forget it. (That kept me out of a number of bad tech stocks during the internet boom years.)
I then check my findings against the wordy bit of the report. For instance, China Shoto says in its interim statement that gross margins rose because the lead price - one of its main inputs - fell. However, the operating margin declined. Something's up there - which the company doesn't explain.
Operating margins are a key figure for comparing companies in the same sector (though adding back depreciation and amortisation gives a more useful result if the companies' policies are very different). This can sometimes be useful not just for spotting recovery stocks, but for assessing their potential value. Suppose I find a company which is making just 3% return on sales, but its competitors are making 8-10% with the same business model. If management can get margins up to 8% within two years, then I can work out what that would be on flat sales (or sales slightly down, if they're aiming to cut out unprofitable lines of business), and estimate what earnings per share would be at that level of operating margin. Then just apply a PER to it and hey presto - I have my target value.
Profitability
I also look at a number of ratios that compare the balance sheet and the profit and loss account - relating profit to the capital the company uses to generate it. (These are figures that always seem to be missed out of even quite educated reporting, such as the Investors Chronicle.) You can use return on assets, return on capital employed, and so on. ROA has the…
