top of page

Red flag #1: Stock-Based Compensation

Let’s talk about financial statement analysis today. It may not necessarily be the most interesting topic for many of you out there, but I believe some basic understanding of accounting can help you understand the language of business better. Furthermore, it allows you to filter out many companies that are not worth investing in (immediately) as part of your investment research process. And trust me, you don’t have to be an accountant to grasp the information I'm about to share with you.

Most people are intimidated by the pages upon pages of information that make up financial statements – they don't make for the most exciting read. But there's gold hidden in the details.

You may have asked yourself the following questions:

  1. Where do I find the financial statement(s) of a company I'm interested in?

  2. How do I begin when I've got my hands on a financial statement?

  3. Is all information in financial statements equally important?

All very valid questions! The first question is easy to answer. You can go to the website of a publicly listed company or simply do a quick Google search to find the company’s annual and quarterly reports. An alternative is a free or paid service that compiles financial information for you. Examples are Yahoo Finance and Tikr.

The second and third questions take a bit longer to answer. However, I'm happy to tell you that you don't have to read financial statements from start to finish. Instead, I will share two key criteria that will help you quickly assess whether it's worth to continue reading a particular financial statement and/or annual report.

Examples of Financial Statement Analysis

The best way to learn more about financial statement analysis is to look at some example data! The snapshots of the data below were taken from my paid account with Tikr. Note that I’m not affiliated with Tikr.

Company A

Financial Statement Analysis as part of the investment research process.
Cash Flow Statement Company A

Company B

Financial Statement Analysis as part of the investment research process.
Cash Flow Statement Company B

Let’s first describe what we see here. These are two examples of partial cash flow statements. In my opinion, the cash flow statement provides me with the most useful information, as it summarises the movement of cash that comes in and goes out of the company. The reality is a bit more nuanced, but let's not care about this for now.

Now that we have the statement in front of us, what are those two key criteria I use to see whether it's worth spending more time researching this company?

  1. Cash-flow positive – I want the cash flow from operations to be positive for several years. In other words, I want the company to bring in more money than it spends (a.k.a. I want the company to be profitable).

  2. Stock-based compensation – I want the ratio of the stock-based compensation and cash flow of operations to be sensible (e.g. a maximum of 10%).

Take a look at both statements now. Can you spot the differences? Now tell me, which one would you rather continue looking at? Will it be Company A which pays its management and employees more in stock-based compensation than cash flow of operations that it brings in? Or Company B which pays its management and employees stock-based compensation that is less than 10% of its cash flow of operations?

I hope you picked company B as more investment-worthy. It is important to understand how the company treats its shareholders before you invest your hard-earned savings in a stock. This may be an extreme example - but wouldn’t you rather be investing with a management that treats you as a shareholder with respect? The company's proxy statements typically provide much more detail about how management and employees are compensated. However, for many US companies, this single number is enough to sieve out many companies that are not investment-worthy.


Thank you for reading!

The Financial Dutchman


Please see our disclaimers.


bottom of page