When Picking Stocks, Derivatives Matter

Even if you shy away from derivatives for your own portfolio, there's a good chance they might still affect your stock gains this year. You may not know it, but derivatives can lead to some potentially big effects on the financials of companies that invest in them -- something worth knowing if you're thinking about plopping down some cash on a stock. Here's a rundown on investing in companies that use derivatives.

Those Darned Derivatives

By now you've heard plenty about using derivatives as an investment choice, but what if one of the companies you're thinking about investing in uses them too? It's a scenario most investors -- and even some analysts -- probably don't even consider.

But I'll admit I'm a little partial. I've got accounting on the brain. I've been spending the last couple of weeks on the financial audit of "a Fortune 500 energy company," and as you might expect, they use lots of derivatives in their day-to-day business.

And that's the case with lots of other kinds of companies, too. Everyone from Southwest Airlines ( LUV) to Allegheny Energy ( AYE) use derivatives (like futures and forwards) to hedge against commodity prices, multinationals use derivatives to limit their exposure to foreign currencies, and financial services companies use derivatives for all sorts of applications.

That all sounds really savvy, but as long as the share price keeps climbing, who cares if companies use derivatives, right? Wrong.

Since U.S.-based companies use "generally accepted accounting principles" ( GAAP) when they deliver their financial statements to investors, it's important to think about some of GAAP's quirks when you're valuing a company to make sure you find any hidden value or "value traps."

Mark it to Market

One of the reasons derivatives are such a special case is because they're " marked to market" on the company's financials. That means that unlike other assets, like inventory, they don't show up on the balance sheet "at cost" -- they're recorded at market value. (For more on, inventory and balance sheets, check out " Getting Started: Inventory Valuation" and " Getting Started: The Balance Sheet.")

Since market values can change a lot, so too can those related balance sheet numbers. But one result of that is often a change in the company's net income for a given period. That's a lot different from how you or I might think of our income -- if my portfolio makes 20% one year, I don't call it a gain until I've sold my positions. Not always so for a company's financials.

So, what does this mean for you? For one, it means that you'll need to look at balance sheet and income statement numbers with a "grain of salt" -- especially if you're investing in a company that owns a lot of derivatives. I'll go into what you should look out for in a minute. But first, don't worry. Just because an investment is marked to market doesn't necessarily mean that it will throw the financial statements out of whack. (For more on income statements, check out " Getting Started: The Income Statement.")

One time when a marked to market can tweak the a company's financials, is when the investment is being used to hedge against risk. (For more on hedging, check out " How to Hedge: Indevus Pharmaceuticals.")

Trimming the Hedges: Cash Flow and Fair Value

There are two main types of hedges we'll think about: cash flow hedges and fair value hedges.

Cash flow hedges. Cash flow hedges are typically used when a company has a payout coming up that they want to protect themselves against. In the airline business, Southwest was able to set itself apart from the competition by using cash flow hedges to protect itself against the rising cost of fuel.

On the financial statements, cash flow hedges flow through as "Adjusted Other Comprehensive Income" -- which, for the uninitiated, means that it doesn't affect numbers like net income and earnings per share ( EPS).

That's a good thing because it means that the company you're looking at is reducing its risk exposure and providing you with understandable financials.

Fair value hedges. Fair value hedges, on the other hand, are used to hedge against fluctuations in the value of an asset like inventory. It is standard practice in the energy industry to "go long" oil, for instance. This protects companies' oil inventories against a drop in oil price.

With fair value hedges, changes in that hedging asset do carry over to the income statement as either a gain or loss on the investment. That's right, folks, these derivatives actually do sometimes have an income statement effect, though normally it's not a big one, since companies are required to use hedges that follow their assets closely.

One of the biggest things to consider, is the effect that inventory hedging has on the inventory itself. When inventory is hedged, the inventory is actually allowed to be marked to market, which usually means that the value of that inventory is much higher than it would otherwise be. This is pretty significant when valuing a company, since key asset numbers and key ratios (like inventory and "asset turnover") can be skewed.

If that's the case for a company you're looking at, you're not going to want to compare its fundamentals directly against a company that doesn't account for its assets that way. (For more on fundamental analysis, check out " Getting Started: Fundamental Analysis.")

Hidden Derivatives

Another situation you might not expect is the hidden derivative. Derivatives don't have to trade on exchanges -- leases and contracts can have embedded derivatives that need to be valued at market value.

This used to be a big problem -- in the pre- Enron days, hard to value hidden derivatives could be accounted for with some wacky financial models. Now, auditors do a pretty good job of making sure that these kinds of instruments appear on the financial statements realistically. (Flashback 2001: For more on Enron, check out " Enron Troubles Only the Tip of the Iceberg?")

Making Sense of Things

With all of the issues derivatives can cause when you're valuing a company, how do you know which end is up? Read the footnotes.

The "Notes to the Financial Statements" section of a company's annual report will lay out all of the treatment they're giving derivatives, and fill in the "why." It should also provide you with alternative numbers you can use to compare fundamentals across companies and industries.

Ask any CPA or CFO -- derivative accounting is one of the trickiest areas in the business world. Now that you know the basics of how derivative investments can affect a company's financials, and where to look to fill in the blanks (the notes), you'll have an edge the next time you think about investing in a company that makes lots of derivative plays.

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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