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Are they looking out for No. 1?

A firm that pays its CEO $100 million in a year had better have a very good reason. (Perhaps he discovered—and patented—the Fountain of Youth? Or found El Dorado and bought it for $1 an acre? Or contacted life on another planet and negotiated a contract obligating the aliens to buy all their supplies from only one company on Earth?) Otherwise, this kind of obscenely obese payday suggests that the firm is run by the managers, for the managers.

If a company reprices (or “reissues” or “exchanges”) its stock options for insiders, stay away. In this switcheroo, a company cancels existing (and typically worthless) stock options for employees and executives, then replaces them with new ones at advantageous prices. If their value is never allowed to go to zero, while their potential profit is always infinite, how can options encourage good stewardship of corporate assets? Any established company that reprices options—as dozens of high-tech firms have—is a disgrace. And any investor who buys stock in such a company is a sheep begging to be sheared.

By looking in the annual report for the mandatory footnote about stock options, you can see how large the “option overhang” is. AOL Time Warner, for example, reported in the front of its annual report that it had 4.5 billion shares of common stock outstanding as of December 31, 2002—but a footnote in the bowels of the report reveals that the company had issued options on 657 million more shares. So AOL’s future earnings will have to be divided among 15% more shares. You should factor in the potential flood of new shares from stock options whenever you estimate a company’s future value.7

“Form 4,” available through the EDGAR database at www.sec.gov, shows whether a firm’s senior executives and directors have been buying or selling shares. There can be legitimate reasons for an insider to sell—diversification, a bigger house, a divorce settlement—but repeated big sales are a bright red flag. A manager can’t legitimately be your partner if he keeps selling while you’re buying.

Are they managers or promoters?

Executives should spend most of their time managing their company in private, not promoting it to the investing public. All too often, CEOs complain that their stock is undervalued no matter how high it goes—forgetting Graham’s insistence that managers should try to keep the stock price from going either too low or too high.8 Meanwhile, all too many chief financial officers give “earnings guidance,” or guesstimates of the company’s quarterly profits. And some firms are hype-o-chondriacs, constantly spewing forth press releases boasting of temporary, trivial, or hypothetical “opportunities.”

A handful of companies—including Coca-Cola, Gillette, and USA Interactive—have begun to “just say no” to Wall Street’s short-term thinking. These few brave outfits are providing more detail about their current budgets and long-term plans, while refusing to speculate about what the next 90 days might hold. (For a model of how a company can communicate candidly and fairly with its shareholders, go to the EDGAR database at www.sec.gov and view the 8-K filings made by Expeditors International of Washington, which periodically posts its superb question-and-answer dialogues with shareholders there.)

Finally, ask whether the company’s accounting practices are designed to make its financial results transparent—or opaque. If “nonrecurring” charges keep recurring, “extraordinary” items crop up so often that they seem ordinary, acronyms like EBITDA take priority over net income, or “pro forma” earnings are used to cloak actual losses, you may be looking at a firm that has not yet learned how to put its shareholders’ long-term interests first.9

Financial strength and capital structure. The most basic possible definition of a good business is this: It generates more cash than it consumes. Good managers keep finding ways of putting that cash to productive use. In the long run, companies