What lessons should investors learn from Enron?

This book is a fascinating account of the how Enron went from transporting natural gas through its pipelines to the foremost commodity (gas, electricity, metals, paper pulp, water, broadband . . . you name it -- even derivatives based on the weather) trading company on the planet to the best known example of corporate malfeasance.

First, in a business sense, Enron fell into what Dr. Jeremy J Siegel in THE FUTURE FOR INVESTORS calls the "Growth Trap." When the company believed that buying a company or other asset would give it a strategic advantage, price was no object.

In 1985 InterNorth paid $70 per share for Houston Natural Gas (HNG) when its market price was only $$46.88. That's the beginning of Enron. A short time later, it paid a hefty price to buy out two "greenmail" investors trying to take it over.

It bought the Portland General electric company to learn how how to run an electric utility and laid fiber optics networks when there was not enough demand.

After their success in trading gas, they thought they could make money from anything . . . so they could afford to pay any cost of entry, because they'd learn how to make it up from future revenues.

When you're making an investment, you're putting up money now in hopes of receiving even more money in the future. Too often, investors will overpay for a stock because they believe that the company has terrific growth prospects.

Secondly, when it began trading natural gas, Enron began a "mark to market" form of accounting. That means that at the end of the day they added up their net losses and profits. This is normal for financial trading firms such as mutual funds.

However, Enron's traders were not buying and selling stocks, bonds and options that have a clearcut market value. They were arranging deals to supply gas here, electricity there . . . for years to come.

Marking these deals to market meant that cash they hoped to receive from customers over the next year or two or ten, was put down as today's profit.

Little or no cash received -- yet on the books a big profit.

And this is what investors do when they check stock prices every day and figure out what their portfolio is "worth." Thinking about the day to day fluctuations takes your mind away from what's important: making more money in your career or business, and buying investments that pay you income over the long term.

In your personal finances, you instinctively know that you can't go to the mall today and spend the dividends or interest you will receive next year. (Yes, in a way you can, by borrowing the money from Visa and planning to repay them later . . . but Visa will charge you a hefty rate of interest for doing that.)

Yet so many people feel "rich" with money they can't spend, just because the market price of their stocks has risen.

Enron's mark to market accounting gave its employees a short-term mentality that in the mid-term proved destroyed its ability to survive into the long-term.

Thirdly, understand that a company's net revenues may be a deceptive number, so keep an eye on its cash flow instead.

This book makes a brave attempt to explain the many off the books limited partnerships Enron created to his its huge debts. I'm an accounting major, but corporate "financial engineering" didn't exist when I was in college, and I found the author's explanations difficult to follow and even more difficult to grasp the real meaning of.

I'm not reassured that professional stock analysts (almost all of whom continued to recommend Enron until it declared bankruptcy) and auditors called in after Enron's downfall also found these limited partnerships difficult to comprehend.

I do understand, however, that if a corporation has a substantial stake in a limited partnership, yet accounting rules do not require it to be on the corporation's balance sheet, there's a lot of room for abuse. Even when these are done with integrity, without the conflict of interest inherent in Enron's, they're manipulating net earnings.

The author therefore advises investors to follow a company's trail of cash. That would be: net sales minus accounts receivable plus interest or dividends received minus cash expenses (ignore depreciation and amortization) minus taxes paid minus dividends paid should equal the increase in company's cash or equivalent investments.

If there's a big gap, that's a red flag. Where is the missing cash? In an off the books entity?

And is there a big gap between that and reported net earnings (that's not explained by depreciation and amortization)?

Of course, not many nonaccountants are going to take a balance sheet and properly analyze it. And I'm not even sure this formula would have worked for Enron, since they were booking deals for future payments as today's "sales," just because the deals were made today.

The best way I know of to check whether a company is properly managing cash flow is . . . find out what's their dividend yield.

A company paying dividends may not be 100% honest, but at least they're in good enough shape to share some of the loot with their stockholders. They're managing the cash flow well enough for that.

This book documents the rise (and fall) of Enron's stock price, but never once mentions the company paying a dividend. No doubt the company's executives felt they could better direct the use of their retained earnings better than mere common investors.

Since they made tens of millions of dollars from selling Enron stocks, what did they care about the fools who held on to it?

Lastly, don't depend on any one stock to make your retirement. No matter how successful a company seems (FORTUNE named Enron as the most innovative company in America every year 1996-2001. Shortly before Enron's collapse, they named the company as one of ten stocks to last the next 10 years. Jeffrey Skilling -- is he still in jail, I wonder? -- was named as top CEO), you can't know its future with certainty.

Even if you work there -- many Enron employees lost their retirement funds because they had no idea what the top executives were hiding from them. Heck, even the very top executives claimed they didn't know about the limited partnerships.

So no matter how good a stock's story or who recommends it to you, you are taking a bigger risk than you realize when you buy the stock of one company.

If you must, choose one that pays dividends. That doesn't guarantee the company will survive, but it gives you better odds.

Stories sell.

Find out how you can have Richard help you sell more products and services through dramatic sales copywriting