Although more than a decade has passed, the name ‘Enron’ continues to hold notoriety in the investing community.

Enron’s 2001 bankruptcy destroyed more than $60 billion of shareholder value. At the time of its bankruptcy, Enron was the seventh-largest company in the United States.  Additionally, Enron’s $63.4 billion in assets made it the largest bankruptcy ever (until it was surpassed by Worldcom’s bankruptcy in the following year).

The devastation of the Enron scandal can also be seen at the security level. Between mid-2000 and the company’s bankruptcy announcement, Enron’s stock declined from a high of $90.75 to a low of below $1.

Clearly, Enron was a poor investment. However, these types of isolated, terrible investment returns should not discourage market participants from continuing to invest moving forward.

Every failure is an opportunity to refine your investment strategy. Enron is no different. With that in mind, this article will describe 5 actionable investing lessons that can be learned from the Enron scandal.

Business Overview

Before diving into some actionable lessons that can be taken away from Enron’s bankruptcy, it will be useful to understand the company’s complicated business model.

Enron was an American energy company that formed in 1985 after the merger of Houston Natural Gas and InterNorth.

The merger was primarily facilitated by Kenneth Lay, who was Houston Natural Gas’ CEO before the merger was completed. Post-merger, Lay served as Enron’s Chairman and CEO for most of its existence. Lay was indicted for more than 10 counts of securities and wire fraud after the Enron accounting fraud was exposed.

In some ways, Enron’s business was similar to an Exxon Mobil (XOM) or Chevron (CVX). Enron owned and operated assets in the oil and gas industry such as pipelines, refineries, and electricity generation stations.

What complicated Enron’s business structure – and differentiated it from larger peers like Exxon or Chevron – was the company’s involvement in the financial markets.

Enron made extensive use of commodity derivatives to make money. This differs from the use of derivatives by many of the larger oil & gas supermajors because these larger businesses use derivatives primarily to reduce risk – or to hedge, in other words. In particular, many energy companies use derivatives to hedge against unwelcome changes in commodity prices.

Enron’s risky, profit-driven derivative activities were encouraged by the economic climate of that time period. It was a period of deregulation in the financial markets, which allowed companies like Enron to place large, risky bets on the future prices of various commodities.

Enron’s bankruptcy also came directly after the dot-com bust, when overvalued Internet stocks came crashing down from peak valuations and resulted in a widespread market recession. Surprisingly, Enron was a part of this mania before the bubble popped.

In 1999 – the middle of the dot-com bubble -the company created Enron Online, an electronic commodity & commodity derivatives trading website. Amazingly, Enron was the counterparty to every transaction made on Enron Online. For obvious reasons, this presented risks if commodity prices moved against the company.

However, the markets failed to accurately perceive these risks. In fact, Fortune named Enron ‘America’s Most Innovative Company’ for six consecutive years between 1996 and 2001, partially because of the then-unheard-of commodity trading website that it had created.

In the initial years, trading volumes on Enron Online expanded exponentially; by mid-2000, Enron Online was on pace to execute $350 billion in trades per year. For context, Enron’s entire business had only ~$60 billion in assets. It is not hard to see that Enron had overextended itself.

When the dot-com bubble finally burst and Enron began to suffer from its significant exposure to the most volatile areas of the commodity market, the company’s executives began looking for ways to hide its tremendous losses.

The most widely used – and dangerous – technique used by Enron accountants is called mark to market accounting.

Under this accounting technique, assets are held on a company’s balance sheet at their current value (instead of book value, which is more typical for large corporations). Under a traditional book value accounting scheme, assets are listed at their purchase value less any accumulated depreciation.

Mark to market accounting can work well for businesses that hold many securities (Enron included), but can be very dangerous when extended to other types of assets. This is exactly what happened at Enron.

To hide losses in its commodity business, Enron accountants began applying mark to market accounting to fixed assets, such as pipelines or oil refinery assets. To estimate the current value of these assets, Enron likely used discounted cash flow valuations.

This created a problem for Enron accountants. Discounted cash flow valuations are very tricky because they rely heavily on the quality & accuracy of assumptions about future cash flow, discount rates, and growth rates.

If any of these assumptions prove wildly inaccurate (which is often the case; even the best accountants cannot predict the future), then a discounted cash flow model becomes useless. At Enron, this inevitably happened. Under legal accounting policies, Enron would be required to report an asset write-down on any asset that become less valuable due to variances from previous discounted cash flow assumptions.

These write-downs would lower the company’s GAAP earnings-per-share – Wall Street’s favorite yardstick of corporate performance. For obvious reasons, Enron executives were incentivized to avoid asset write-downs – and earnings declines – whenever possible. To do this, Enron would transfer there assets to off-the-balance-sheet corporations, which would record the loss and avoid reporting declining profits at the Enron parent company.

These accounting policies were simply kicking the can down the road for Enron. Just because the parent Enron company was not reporting these losses did not mean they did not occur in reality. Even worse, Enron’s parent company did report the gains associated with mark to market accounting. In other words, the Enron parent company reported only the beneficial consequences of this accounting scheme.

At the same time, Enron’s capital allocation began to deteriorate noticeably.

Amid the mania of the dot-com bubble, Enron’s board of directors began investing significant sums of capital into broadband telecommunications equipment – expensive assets that never generated a dime of profit for the company’s shareholders.

It is hard to overstate the negative impact of Enron’s poor investments outside its circle of competence. In one of the company’s last quarterly earnings releases before bankruptcy, its fledgling telecommunications segment reported an operating loss of $137 million.

In 2001, everything began to fall apart for Enron executives and shareholders.

Kenneth Lay resigned as CEO in February, to be replaced by Jeffrey Skilling. Skilling resigned in August, Lay resumed the CEO post, and Enron eventually declared bankruptcy in December. Enron was delisted from the New York Stock Exchange in the following month.

Moving on, the next sections will discuss 5 actionable lessons that investors can learn from the Enron scandal to improve their personal investment strategy.

Lesson #1: Don’t Invest in What You Can’t Understand

Thanks to its heavy involvement with commodity derivative trading and Enron Online, Enron had a very complicated business model that many investors did not fully understand.

In fact, Warren Buffett – literally the most successful investor ever – claimed that even he did not understand some of the transactions described in Enron’s financial statements:

Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.”

– Warren Buffett in the 2002 Berkshire Hathaway Annual Report (emphasis mine)