Financial Statements,

Cash Flow, and Taxes

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Suppose you are a small investor who knows a little about finance and accounting.

Could you compete successfully against large institutional investors with armies of an-

alysts, high-powered computers, and state-of-the-art trading strategies?

The answer, according to one Wall Street legend, is a resounding yes! Peter

Lynch, who had an outstanding track record as manager of the $10 billion Fidelity

Magellan fund and then went on to become the best-selling author of One Up on Wall

Streetand Beating the Street,has long argued that small investors can beat the mar-

ket by using common sense and information available to all of us as we go about our

day-to-day lives.

For example, a college student may be more adept at scouting out the new and

interesting products that will become tomorrow’s success stories than is an investment

banker who works 75 hours a week in a New York office. Parents of young children are

likely to know which baby foods will succeed, or which diapers are best. Couch pota-

toes may have the best feel for which tortilla chips have the brightest future, or

whether a new remote control is worth its price.

The trick is to find a product that will boom, yet whose manufacturer’s stock is

undervalued. If this sounds too easy, you are right. Lynch argues that once you have

discovered a good product, there is still much homework to be done. This involves

combing through the vast amount of financial information provided by companies. It

also requires taking a closer and more critical look at how the company conducts its

business—Lynch refers to this as “kicking the tires.”

To illustrate his point, Lynch relates his experience with Dunkin’ Donuts. As a

consumer, Lynch was impressed with the quality of the product. This impression led

him to take a closer look at the company’s financial statements and operations. He

liked what he saw, and Dunkin’ Donuts became one of his all-time best investments.

The next two chapters discuss what financial statements are and how they are

analyzed. Once you have identified a good product as a possible investment, the

principles discussed in these chapters will help you “kick the tires.”

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