However, there are a few quantitative tests to help an investor gauge management quality. I find them helpful as a "red flag" kind of measurement. Here are a few things to look for.
Does management make more money than shareholders?
Look at management compensation disclosures in form 10-k (sometimes it's part of the proxy statement filed under form DEF-14A, sometimes in other places too, depending on the company -- some ADRs do it differently too).
How much money is management making in comparison to the company itself? If management collectively makes more money than is left for shareholders, it's a clear sign of improbity -- stay away.
Does management get raises regardless of how shareholders fare?
In other words, is compensation aligned with shareholders results? Look for how options are granted, at which strike price: fair market value or some other made-up value that is likely to benefit management only at the expense of shareholders?
Look for the criteria how stock options are granted. Is it purely share price or earnings based? Or there are more objective criteria such as long-term trends, ROI, cost reductions and margins (such as operating margin)?
Also: is management compensation growing faster than dividends? That could be a warning sign.
Are ROE, ROI, ROA trending up or down? Are they satisfactory for the industry?
Good ratios tend to show good management, but don't forget to factor in peculiarities of each industry as well. While ROE will typically be bad for companies in a bad industry such as airlines, huge disparities in ROE for example can mean excessive risk (high leverage) or poor management. For banks, low ROA (1-2%) is okay, but too low and management is probably doing something wrong.
Did the stock price reflect at least $1 for each $1 of retained earnings?
This is a Warren Buffett's favorite. If the share price over the long run (say 5-10 years) hasn't fully appreciated $1 for each dollar of retained earnings, it means the company is being undervalued by the market, which could happen for two reasons: 1) the market is consistently irrational and it's probably time to buy, buy, buy or 2) the market has little faith to believe the retained earnings will be deployed wisely (say, management is likely to waste money on acquisitions or endeavor into money-losing strategies) .
You have to figure out for yourself what's the case here, but over a very long time, if the stock price fails to reflect at least the retained earnings it's most likely a reflection of poor management.
Don't forget to take into account dividends. If dividends were paid, these were not retained earnings, so they should be factored out.
Does management capitalize things that should be expensed?
Capitalizing an expense is putting the expense as an asset on the balance sheet and depreciating (taking charges against it) over time. Capitalizing an expense is an aggressive way of managing the company's financials and is typically wrong, no matter what the explanation. AOL once capitalized its advertising costs, under the excuse that advertising was an investment for the long-term and that it would eventually earn its fruits over time. While this can be true, it's not the proper way of reporting an expense, which is what advertisement is.
The best way to think of this is the following: does it involve an outlay of cash? If so, it's an expense. Period. The only exception is goodwill, which is the amount companies overpay for assets (when they acquire other companies, for example). But even then, a lot of goodwill on the balance sheet is probably not a good sign either.
Do earnings come from "other" sources?
If an airline makes the bulk of its money by trading fuel in the futures market and not by operating airplanes to transport people and goods, then its earnings do not reflect its line of business. While this is an obvious example, in many cases it's hard to assess what is part of recurring revenues and what is extra income from "other" sources.
Too many gains from trading in financial markets doesn't bode well for a non-investment or holding company.
Watch out for too large financial transactions for non-financials, making money on fees paid by franchisees, or even the unscrupulous and dishonest practice of lending of money to subsidiaries just to have it come back again as dividends from these same subsidiaries (trust me, it happens).
Does management try to obfuscate (bad) financial results?
If a company's financial report contains any of these:
- Too hard to decipher;
- Too many one-time items that smell like recurring items;
- Too many off-balance-sheet commitments;
- Lots of related-party transactions that benefit management's family and friends but are not in the main interest of shareholders;
- Contains too much accounting gimmickry, constant changes in accounting procedures or excessive and unnecessary use of accounting lingo.
Does management think and act like owners?
This one is very subjective and more qualitative than quantitative. But it means that if throughout reading a company's annual report you find yourself thinking that management is not candid about the company's current situation (if it's poor), if it's too optimistic, conceals or minimizes bad news or overall gives you an impression that they're not doing what you as a shareholder would do, then jump ship -- you're likely dealing with a prima donna and not a true owner.
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