Chapter 5
Analyzing a Company’s Profitability Using the Income Statement
IN THIS CHAPTER
Understanding what a company’s profit is and how it’s reflected on the income statement
Finding out why learning to analyze the income statement is key to fundamental analysis
Digging into how to read an income statement and to understand a company better
Discovering how to compare a company’s reported profit to what is expected
In everything from sports to school, you’ve probably been trained to measure results. At the end of the game or class semester, you either get a score or grade that determines how well or poorly you did, and how you measured up to expectations and ranked against your peers.
When you measure the success of a company, you really don’t do anything differently than when you gauge the results of last night’s basketball game. Fundamental analysts carefully evaluate a company’s income statement to see how well the company did, examining how much money it brought in, how much it spent to operate, and the final amount of profit it generated.
Companies lay out all of their critical information for you in their income statement. In this chapter, you dig into the parts of the income statement necessary for fundamental analysis. Better yet, this chapter gives you the tools to know how to read those parts, which is critical when you want to determine whether a company’s stock is cheap or expensive (see Chapters 10 and 11 for more on determining a stock’s worth). Don’t let the cryptic appearance of the income statement scare you. The pointers in this chapter prepare you to get everything you need out of the income statement.
Digging Deep Into the Income Statement
When you invest in a company by buying its stock, you’re probably not doing it to be charitable. By buying shares of stock, you’re claiming a piece of the company’s future revenue and profits. If all goes well, the company will grow and your stake will become more valuable.
The trick, though, is making sure the company is keeping its end of the bargain by generating a profit. That’s where the income statement comes in. Companies that have issued stock on a stock market exchange such as the New York Stock Exchange or Nasdaq, or borrow money from the public, are required to issue an income statement. The income statement spells out in exhaustive detail how the company did during each quarter and year. Fundamental analysis requires you to pay close attention to the income statement for any sign the company isn’t progressing as it should or, conversely, doing better than many thought it could.
No two income statements look identical, and subtle differences can make comparing one company’s income statement with other companies’ problematic (you can read about making comparisons more in Chapter 16). Income statements can also vary a bit depending on what line of business a company is in. Luckily for investors, the accountants have somewhat standardized the way companies must prepare the income statement. Income statements tend to follow the same basic structure.
You can dedicate a great deal of time obsessing over every nuance of financial statements, including the income statement. If that’s of interest to you, check out Reading Financial Reports For Dummies (Wiley), which gets into the nitty-gritty of financial reporting. In this book, the one you’re holding, you’ll get a look at the basic layout of the income statement and what you’ll need to do some serious fundamental analysis.
The basic structure of an income statement includes these items:
- Revenue: This is how much money the company brought in by selling goods and services. Revenue is often called the “top line.”
- Cost of goods sold: It takes money to make money. Cost of goods sold measures what a company must spend to actually create the good or service sold. These are direct costs, meaning they are costs for items that may literally go into the products. Cost of goods sold, for many manufacturing companies, is the largest single expense of doing business. For instance, with an automaker, the cost of goods sold might include the cost of steel used to build the cars.
- Operating expenses:Indirect expenses are incurred by companies as they conduct business, but may not go directly into the product. These costs are usually necessary or important, but peripheral. These indirect costs are called operating expenses or better known as overhead. Operating expenses may include:
- Marketing expenses: Include advertising and other promotional expenses.
- Research and development: What a company spends to cook up new products or services to sell to customers.
- Administrative expenses: Expenses connected with support staff, such as legal, human resources, and other functions that are directly tied to manufacturing the product.
- Other income: Companies sometimes bring in money for things other than selling products and services. This income is recorded as other income. For instance, a company might win a legal settlement or sell a factory.
- Other expenses. Just as “other income” doesn’t qualify as revenue, other expenses do not qualify as normal operating expenses. Other expenses might include the cost to restructure a unit of the company, paying severance to lay off employees, or depreciation — accounting for wear and tear (see the sidebar, “Appreciating depreciation”).
- Earnings before interest and taxes. After you subtract cost of goods sold, operating expenses, and other expenses from revenue, what you’re left with is earnings before interest and taxes.
- Interest expense. Most companies borrow money to fund their operations or to buy inventory. Here, the company discloses how much it’s paying to borrow money.
- Taxes. Companies must pay taxes too. Here, companies disclose how much they paid to Uncle Sam.
- Net income. Finally, after paying all these costs and expenses, what’s left is the profit, or net income. This is how much the company earned during the period, based on accounting rules or GAAP.
Ever hear a company say it used GAAP? No, that doesn’t mean they used expense accounts to buy khakis and collared shirts at a popular clothing store. Instead, I’m talking about GAAP — Generally Accepted Accounting Principles — painstakingly detailed rules that instruct companies on the right way to report results.
Taking in the Top Line: Revenue
For a fundamental analyst reading an income statement, revenue is a critical item because it tells you how:
- Rapidly the company is growing (or shrinking): Comparing revenue generated during a year or quarter with revenue reported in the same period a year ago can be very telling. This simple comparison tells you whether the company’s growth is on an uptrend or downtrend.
- Strong demand is for a company’s products: Companies love to brag about how popular their products are. But revenue is where hype can be quantified. Strong demand for a product will show up in the revenue line, even if the company’s expenses are out of line and still losing money.
- A company ranks in sheer size next to its rivals: While there are many ways to measure a company’s size, such as number of employees, revenue is as good a benchmark as any other. If you want to find out which company is the biggest in a competitive field, you should always check out revenue first.
Fundamental analysts pay close attention to revenue for the reasons listed here, but there’s also reason to be skeptical. Accounting rules give companies a great deal of leeway in how and when they record or “recognize” revenue. The most classic distortion may occur when a company books revenue before the product is actually bought or received by a customer. Regulators, for this reason, routinely warn companies to be more conservative when booking revenue. The General Accounting Office, a unit of the government charged to study waste in both the private and public sectors, found that improper revenue recognition was to blame for more than a third of misstated financial statements. Always be skeptical of revenue.
Breaking down a company’s revenue
Most companies will provide several revenue figures. Generally, there will be a total revenue line that totals up the money the company brought in from all its business units. But if the company is complex, it might break total revenue down into its component parts so you can see which units are performing best.
Due to its large size and wide array of technology businesses, International Business Machines is a great example of how you can use the revenue line to peer deeply into a company’s operations. Table 5-1 has a breakdown of IBM’s 2021 results, to give you an idea of how digging into what makes up total revenue can be revealing about a business:
TABLE 5-1 IBM’s Total Revenue Breakdown in 2021
Source of Revenue | Revenue (in Billions) |
|---|---|
Software | $24.1 |
Consulting | $17.8 |
Infrastructure | $14.2 |
Financing | $0.8 |
Other | $0.4 |
Total revenue | $57.4 |
Source: Data from IBM annual report
As you can see in Table 5-1, had you just looked at total revenue you would have missed a helpful breakdown in IBM’s business. Dissecting IBM’s revenue into units gives you several key findings, including a:
- Sense of a company’s business diversification. While IBM is best known for making large corporate computer systems, in reality the company gets its revenue from a swath of technology businesses. No single line of business accounts for more than half of total revenue. As a fundamental analyst, this is important information because it tells you whether IBM is overly concentrated in an area of technology you’re not optimistic about. Similarly, this analysis will tell you if the company exposes you to the area of technology you want to invest in. For instance, if you want to invest in technology hardware, IBM probably isn’t the best for you.
- Indication of the most important business at the company. Investors may not realize it, but IBM is more of a technology software firm than anything else. It got more than 40 percent of its revenue from software in 2021.
- Clue of reliance on noncore businesses. Over the years, it’s common for large companies to branch into businesses that are outside their core business. Several large companies, like General Electric and General Motors, have practically spawned banks as they extend credit to customers buying their products. Straying from a core business is something you, as a fundamental analyst, need to pay close attention to. GE spent much of 2014 and 2015 selling off its financial businesses. And following its bankruptcy restructuring, GM’s big bank operations were spun off into a different company, called Ally. With IBM, you can see the company has a financing business that provides loans to customers. However, the financing business is a very small portion of its total operation at a little more than 1 percent of revenue.
If you want to figure out how large a unit of a company is, divide the unit’s revenue by total revenue and multiply the result by 100. Using IBM’s financing unit as an example, divide the unit’s revenue of $0.8 billion by IBM’s total revenue of $57.4 billion to arrive at 0.014. Multiply 0.014 by 100 to convert the result into a percentage of 1.4 percent.
Keeping tabs on a company’s growth
If there’s one thing many investors will agree on, it’s the importance for a company to keep growing. As the prices of raw materials rise, it’s critical for companies to keep up by increasing revenue either by raising prices or creating new products with higher price tags. Even if you’re investing in a mature industry, just looking for a stable return, you still want to see revenue increasing over time so the company’s earnings keep up with inflation.
Finding out how rapidly a company is growing is simple if you know your way around the income statement. Here’s what you need to know:
Download the historical revenue data.
You’ll first need to get your hands on the revenue data. The best way to do this is by downloading the income statement from an online source. You can review how to do this in Chapter 4.
Pull out the revenue line item for several years.
In most cases, one of the very first lines in the income statement is total revenue. Pull out total revenue from the income statement and place it in a spreadsheet or write it down so you can do further analysis.
Again using IBM as an example, Table 5-2 shows you how to put IBM’s total revenue into a format you can further analyze.
TABLE 5-2 IBM’s Annual Revenue
Year
Total Revenue (in Billions)
2021
$57.4
2020
$55.2
2019
$57.7
2018
$79.6
2017
$79.1
2016
$79.9
2015
$81.7
2014
$92.8
2013
$98.4
Calculate the year-to-year percentage change.
Now that you have each year’s total revenue in one place, you can calculate the company’s revenue growth from year to year. Calculating percentage changes is covered in more depth in Chapter 4. But the way I like to remember this is that you subtract the “old” number from the “new” number, and then divide by the “old” number and multiply by 100.
Consider an example calculating IBM’s 2021 revenue growth. Start by subtracting the “new” number, the 2021 revenue of $57.4 billion, by the “old” number, which is the 2020 revenue of $55.2 billion. It looks like this (note the answer is positive because IBM’s revenue rose in 2021.):
$57.4 – $55.2 = $2.2
Next, divide the difference between the new number and the old number, which you just calculated, by the “old ‘number. It looks like this:
$2.2 ÷ 55.2 = 0.04
Fundamental analysts love percentages (doesn’t everyone?). So, let’s convert the decimal to a percentage by multiplying by 100:
0.04 × 100 = 3.98 percent
This analysis shows you IBM’s total revenue grew by nearly 4 percent in 2021.
Repeat step 3 for each year so you can see a multiyear trend.
If you’re using a calculator to do steps 1 through 4, here’s something to be aware of: If you clear out the calculator’s memory after each step, you’ll get 4 percent instead of the more accurate 3.98 percent. That’s because when you clear the calculator, you’ll get a rounding error. To avoid this error, just do each step after the next and the solution won’t get rounded. Or you could just use a spreadsheet, which doesn’t round unless you tell it to.One year’s revenue change doesn’t really tell you much. The fact that IBM’s revenue rose 4 percent is of limited value unless you compare it with something else. You may compare IBM’s growth to its competitors’ growth, as you will read more about in Chapter 16. But for now, you will want to see how 2021 revenue growth compares with growth in past years. I’ll save you the trouble by calculating the percentage changes and presenting them in Table 5-3.
Now that you have each year’s revenue growth, you can see just how rocky revenue can be, even at a large company like IBM. You’ll notice revenue grew by as much as 4 percent in 2021, and shrunk by up to 28 percent in 2019. Understanding just how uneven revenue growth can be from year to year, is critical to the work of fundamental analysis because you can see whether a firm is cyclical. A cyclical company is one that experiences large swings in revenue based on the health of the overall economy. As an investor, you might not be willing to pay as much for shares of a cyclical company if the economy is about to enter into a period of slower growth.
TABLE 5-3 IBM’s Annual Revenue changes
Year
Total Revenue Percent Change
2021
3.9
2020
–4.4
2019
–27.5
2018
0.6
2017
–1.0
2016
–2.2
2015
–11.9
2014
–5.7
2013
–4.4
2012
–3.8
Resist the temptation to take simple averages of revenue growth and assume that average growth will continue forever. For instance, if you averaged IBM’s growth between 2012 and 2021 by adding up the growth numbers and dividing by the total number of years, you’d find the company shrunk, on average, by 5.6 percent a year. But look what actually happened between those years. IBM’s revenue actually fell in eight out of the ten years. Fundamental analysts dig deeper and study year-to-year changes, to see how revenue ebbs and flows.Don’t forget to also calculate the percentage changes of growth in the different business units. Taking the time to see how rapidly different parts of the business are growing can give you a peek into the company’s direction. At IBM in 2021, for instance, the software unit grew the most rapidly by rising 5.2 percent over 2020, while the financing unit shrunk by 21 percent. As a fundamental analyst, you might look into IBM’s software unit further for more explanation.
What are the company’s costs?
With very few exceptions, companies don’t keep all the money they collect from customers. A good portion of the revenue goes out to pay direct costs, such as raw materials, and indirect costs like overhead and advertising. All these costs are recorded in the income statement so investors may see how much a company spent to generate revenue.
Digging into costs
If you’re beginning to notice a trend here, one of the biggest skills in fundamental analysis is the ability to tear apart the numbers and see what comprises them. Analyzing a company’s costs is a great example. While some investors just look at total expenses, or maybe consider cost of goods sold and operating expenses, there’s much intelligence to be had by digging deeper.
To show you what I mean, let’s crack open the financial can on Campbell Soup. The income statement shows you how much it costs to make a can of soup, among the other products the company manufactures, as you can see in Table 5-4.
Again, don’t let the table of numbers overwhelm you. Fundamental analysts rely on two simple but powerful techniques to convert a pile of numbers into meaningful data. With just a little math, you’ll be able to analyze the data and paint a picture that tells you a great deal about Campbell Soup.
TABLE 5-4 Breakdown of Campbell Soup’s 2021 Costs
2021, in Millions (Fiscal Year Ended August 1, 2021) | 2020, in Millions (Fiscal Year Ended August 2, 2020) | |
|---|---|---|
Revenue | $8,476 | $8,691 |
Cost of goods sold | $5,665 | $5,692 |
Marketing and selling expenses | $817 | $947 |
Administrative expenses | $598 | $622 |
Research and development expenses | $84 | $93 |
Other expenses or (income) | ($254) | $221 |
Restructuring charges | $21 | $9 |
Source: Data from Campbell Soup annual report
Here are two of my favorite — and relatively — easy ways to analyze trends.
Common-size analysis: One of the best tricks used in fundamental analysis is common-sizing. Common-sizing is simply taking lines on financial statements and quantifying their size by comparing them to a total. When common-sizing is applied to the income statement, you compare each expense to revenue. That way, you can easily see whether the company’s expenses are growing at an alarming pace compared with the growth of the business.
Best of all, common-sizing is simple. All you need to do is divide each cost and expense by total revenue and multiply by 100 to convert the number into a percentage. Start with Campbell Soup’s cost of goods sold in 2021. Divide the cost of goods sold of $5,665 by the company’s total revenue of $8,476 and multiply by 100. You should get 66.8 percent. In other words, the cost of making soup and other products cost 67 cents of every dollar of revenue. Next, follow the same directions for all the costs on Campbell Soup’s income statement. Table 5-5 shows you what you’ll find when you’re done.
Looking at the numbers in Table 5-5, you’ll probably notice that the percentages haven’t changed much from 2020 to 2021. That is likely a sign that the company is doing a good job keeping the growth of expenses in check and moving at pace with the business. The one very slight exception is the cost of goods sold. In 2021, the company spent 66.8 percent of revenue on costs to produce products. That went up very slightly from 2020. It’s a minor change, but points to an issue that’s worth digging into further. Perhaps the company’s raw materials costs rose slightly, due to inflation, or more customers are buying goods that cost slightly more to make.
TABLE 5-5 Common-Sized Campbell Soup
2021, Expenses as a Percent of Revenue
2020, Expenses as a Percent of Revenue
Cost of goods sold
66.8
66.5
Marketing and selling expenses
9.6
10.9
Administrative expenses
7.1
7.2
Research and development expenses
1.0
1.1
Other expenses or income
–3.0
2.5
Restructuring charges
0.2
0.1
When you common-size an income statement, it’s often best to use several years of data so you can see the trends from year to year. If a company’s research and development budget is soaring, for instance, you’ll spot the trend. Often an unusual blip on the common-sizing will clue you into something worth looking further into. For instance, Campbell’s cost of goods sold has been fluctuating relative to revenue for years. The company’s costs of goods sold divided by revenue was higher in 2021 than it was in 2020. But it’s not a radical departure. Costs of goods sold to revenue was the same in 2019, 66.8 percent, as it was in 2021.- Measuring the changes in costs and expenses: Common-sizing is great — but it has its limitations. Turn into an analysis ninja by keeping tabs on how rapidly costs and expenses are growing from year to year. Measure the growth of costs and expenses in the same way as measuring the growth in revenue earlier.
What is the company’s bottom line?
After paying all the bills, including all the direct costs, operating expenses and taxes, what’s left is the company’s net profit.
The basic formula is as follows:
Revenue – cost of goods sold – operating expenses + other income – other expenses – interest expense – taxes = Net Income
Net income is the end-all, be-all for many investors. It’s the number that is used to see how a company did compared with the past and versus expectations investors had. You will want to see how rapidly net income grew or shrunk compared with previous years.
One of the great ways to glean insights in fundamental analysis is by mashing up or combining several metrics. Here’s a great example: Try combining what you know about net income with your new ability to calculate growth. If you notice that a company’s net income is growing more slowly than revenue, that’s a quick tip-off that its expenses might be running amuck.
An efficient way to see how net income is faring next to revenue is to calculate the year-over-year percentage changes for revenue and for net income. By placing the growth of revenue and net income side by side, you’ll see, very quickly, how well the company is controlling costs as demand for its products rises and falls. You’ll see what this analysis looks like for Campbell Soup in Table 5-6. The fact that Campbell’s net income has fallen in three out of the past five years shows how the company is having difficultly controlling costs. Anemic revenue growth — including a decline in revenue in 2017 and 2021 — isn’t helping matters, either.
TABLE 5-6 Campbell Soup’s Growth in Revenue and Income
Year (Fiscal) | Percent Growth in Revenue | Percent Growth in Net Income |
|---|---|---|
2021 | –2.5 | –38.5 |
2020 | 7.2 | 671.6 |
2019 | 22.6 | –19.2 |
2018 | 13.3 | –70.6 |
2017 | –26.7 | 57.5 |
Calculating Profit Margins and Finding Out What They Mean
If you hear a company made $400 million last year, you recognize that sounds like quite a bit of money. Woohoo! But wait. Fundamental analysis requires taking things a step further. Fundamental analysis gives you the tools to put net income into perspective and understand what it means for you as an investor.
Differences between the types of profit margins
One of the best ways to size up a company’s profit is by studying profit margins. At its most basic level, a profit margin is how much a company has left after paying for its expenses. However, there are several ways to measure profit margins, all of which are instructive in fundamental analysis. There are three main types of profit margins fundamental analysts should be aware of, including:
Gross profit margin
A company’s gross profit, also called gross margin, is one of the simplest ways to look at profitability. Gross profit is what’s left of revenue after subtracting direct costs, also known as cost of goods sold. Gross profit measures how much the company makes after paying costs directly connected with producing the product.
The gross profit percent takes things a bit further by comparing gross profit with a company’s revenue. In other words, the gross profit percent tells you how much of revenue is kept, after paying direct costs, relative to sales. If this sounds familiar, it should. The gross profit percent is exactly what you get when you common-size a company’s gross profit. You just can’t get away from common-sizing now, can you?
Here’s an example: Caterpillar. The maker of earthmoving and construction equipment reported revenue of $51 billion in 2021, and its cost of goods sold reached $35.5 billion. By subtracting $39.8 billion from $55.2 billion, you find Caterpillar’s gross profit was $15.5 billion. That’s great, but doesn’t tell you much. Here’s where fundamental analysis comes in. Divide the company’s $15.5 billion gross profit by its total revenue of $51 billion and multiply by 100. This quick division tells you Caterpillar had a gross profit percent of 30 percent.
What’s that mean in plain English? After paying for direct costs, such as steel and laborers’ time on the assembly line, Caterpillar kept 30 cents of every dollar in revenue. Just to give you an idea what gross profit percentages typically are, among the 500 companies in the Standard & Poor’s 500 index, the average gross profit percent is about 45 percent, says Thomson Reuters. The fact Caterpillar’s gross margin percent is lower shows just how much of the firm’s costs are concentrated in raw materials and other direct costs.
Gross profit percent is not as useful when studying software and Internet companies. A vast majority of the cost of producing software is overhead, and not direct costs. That’s one reason why Microsoft has very large gross profit percentages. For instance, Microsoft kept 69 cents of every dollar of sales after paying direct costs during its fiscal 2021 year, which ended June 30, 2021. But its operating profit percent, which reflects a more complete picture of the many costs to create software, is much lower, as we’ll discuss next. Gross profit percentages change, too, along with the business. Now that Microsoft is making more than software, including Surface computers and tablets, its gross profit percent has fallen. Microsoft’s gross profit percent was more than 80 percent in 2008.
Operating profit
A company’s operating profit, also called operating margin, factors in more costs than the gross profit does. Operating profit not only factors in a company’s direct costs, but indirect costs, too. Operating profit is what’s left of revenue after subtracting overhead costs and cost of goods sold.
Taking things a step further is the operating profit percent. The operating profit percent is calculated by dividing operating profit by revenue. It tells you how much the company keeps of revenue after paying direct costs and overhead. Operating profit percentages are critical indicators for fundamental analysis, because they give a good idea of how profitable a firm is with respect to its core business.
Going back to Microsoft shows clearly why for some businesses, the operating profit percent is more meaningful than gross profit percent. The operating profit percent includes the costs of research and development and advertising, for instance, which are important to generating successful software products. Table 5-7 shows you how operating profit percent is calculated.
TABLE 5-7 Figuring Microsoft’s Operating Profit Margin
Fiscal 2021 Result | Amount (in Millions) |
|---|---|
Total revenue | $168,088 |
Minus cost of goods sold | –$52,232 |
Minus research and development expenses | –$20,716 |
Minus sales and marketing expenses | –$20,117 |
Minus general and administrative expenses | –$5,107 |
Equals operating profit | $69,916 |
Operating profit percent | 41% |
Source: Microsoft press release
Here you can see why Microsoft is considered to be such a profitable company, with its enviable 41 percent operating profit percent. This operating profit percent is about double the average 18 percent operating profit margin of companies in the Standard & Poor’s 500, says Thomson Reuters.
Calculating operating profit can vary a bit depending on who you are talking with. Microsoft is a great example of how operating profit can be calculated differently by different analysts. During fiscal 2015, the company took a $10 billion impairment charge associated with its purchase of mobile phone maker Nokia. The company itself subtracted this charge to arrive at operating profit. But fundamental analysts often omit such charges when calculating operating profit because they’re not part of normal operations and not expected to repeat (let’s hope). That sounds reasonable to me. But some fundamental analysts go even further and leave out other expenses that are not actual costs. For instance, operating profit subtracts depreciation from revenue, even though depreciation isn’t an actual bill the company must pay. For this reason, some fundamental analysts recommend ignoring some of these intangible expenses when understanding how much a company is worth, as will be discussed further in Chapter 11.
Net profit margin
Given how important profit is to investors, it’s no surprise there are many words to describe the company’s bottom line. A company’s net profit, net margin, or net income is the most comprehensive measure of profitability. Net profit tells you how many dollars the company kept after paying all its costs and expenses. The net income margin percent, which is net profit divided by total revenue, tells you how much of every dollar in sales the company keeps after paying all costs and expenses.
Companies can lose money, too. When that happens, it’s called a net loss.
At its simplest level, net profit is operating profit minus everything else.
Finding out about earnings per share
You might be wondering by now, “Okay great, the company made millions of dollars. Wonderful. So, what’s in it for me?”
That’s exactly what earnings per share is all about. Usually, one of the last items listed on a company’s income statement is earnings per share, most commonly known as EPS. If net income tells you how large a pie is, EPS tells you, the fundamental analyst, how big your slice is.
EPS is calculated by dividing net income by the number of shares outstanding at the company. A company’s number of shares outstanding is the total number of shares that are owned by members of the public as well as restricted shares held by officers and directors of the company. Restricted stock shares are given to individuals with close connections to the company, such as the executive team of a company that was acquired. Restricted stock comes with strings attached, which may bar the owners from selling for a certain amount of time. The number of shares a company has outstanding is available on the balance sheet, to be discussed more fully in Chapter 6.
Everything you really need to know, though, is right on the income statement, including:
Basic earnings per share: This measure tells you how much of a slice of the company’s net profit you’re entitled to as a shareholder based on the number of shares that are outstanding right now. The formula in its simplest form is:
- Net income ÷ Number of shares outstanding
Some companies have special classes of stock, called preferred stock. Preferred stock is a unique type of stock that gives investors priority with dividends that are often higher than what’s paid on the common shares. These preferred stock dividends, if paid, should be subtracted from net income in the preceding formula when calculating basic earnings per share.
- Diluted earnings per share: When you read stories about how much a company earned, you’re most likely reading about diluted earnings per share. Diluted EPS measures how much the company earned based on each share of stock that could be outstanding at some time in the future. Diluted EPS is commonly used because it’s the most conservative measure of profit per share. It divides net income by the total number of shares that could possibly be outstanding, including the impact of employees converting their stock options into real shares. Diluted EPS is almost always less than basic EPS.
Never underestimate the danger of employee stock options on the value of your claim to a company’s earnings. When employees are given options, and those options become valuable either because the employee works at the company for a set period of time or the stock rises, those shares can be converted into real shares. The avalanche of shares can water down, or dilute, how much of a claim you have on the company’s earnings. This is called dilution, and is a big reason why you need to carefully compare basic EPS with diluted EPS. If diluted EPS is dramatically less than basic EPS, that’s a signal employees might be holding large baskets of options.
Comparing a Company’s Profit to Expectations
Ever wonder why a company’s stock price might fall even after it posts a huge increase in earnings? You can learn more about how to use information from the income statement to determine stock prices in Chapter 10. But it’s critical to realize that profits and earnings don’t always move in lockstep with stock prices.
It’s true that over time, a company with rising revenue and earnings will likely see its stock price rise, too. And as discussed in Chapter 3, correctly forecasting how much a company will earn and how much it will be worth in the future can be great for long-term investing success. Fundamental analysis can help you determine whether a stock is cheap or expensive relative to the company’s revenue and earnings.
But in the short term, stock prices and earnings can seemingly have nothing to do with each other. And that’s where the skill, and a bit of luck, comes in when you try to match fundamental analysis with stock prices. The fact is that in the short term, stocks rise and fall largely based on how a company’s earnings compare with what’s expected.
The importance of investors’ expectations
Remember, when you’re studying a company’s income statement, you’re not alone. There are hundreds, if not thousands of other investors looking at the same numbers and trying to place a price on the stock. They then buy and sell based on their fundamental analysis, to establish the current price.
If the company’s revenue and earnings match what most people were expecting, that means the current stock price was likely correctly set. Only if the other investors were way off will the stock move much higher or lower after a company releases its income statement. You will discover more on this topic later in the book. But the role of expectations for earnings is important to discuss now because it shows that just because you master the income statement doesn’t mean you’ll necessarily be a successful investor.
Comparing actual financial results with expectations
Even before a company puts out its income statement, analysts and other investors have had a chance to guess what they think the company will earn. These earnings estimates are usually based on diluted earnings per share.
These estimates are available online at many places, but here are instructions on how to find them at Yahoo! Finance.
- Log into Yahoo! Finance at
http://finance.yahoo.com. - Enter the symbol of the stock you’re interested in the box in the top center of the screen and click on the name of the company when it appears.
- Click on the Analysis option listed in the navigation bar at the top center of the screen.
- Find the earnings number in the Avg. Estimate row under the quarter you’re interested in. That’s the earnings estimate.
Once the company reports its earnings, you can then compare the actual earnings with the estimate. Figure 5-1 shows what this screen looks like for Microsoft’s earnings.
Source: Yahoo! Finance
FIGURE 5-1: Yahoo! Finance makes it handy to look up what companies are expected to earn.
It can be tricky to get an apples-to-apples comparison between the analysts’ EPS estimate and the actual reported EPS from the company. While analysts will usually forecast operating earnings, companies may sometimes include unusual and nonrecurring items that make comparison with the estimate problematic. For that reason, many companies attempt to help investors by offering pro forma earnings. Pro forma earnings don’t follow GAAP. Instead, adjustments are made by the company to make the reported EPS match the estimate.
There are also some interesting innovations in getting earnings estimates from more investors. Most official earnings estimates are generated by polling the Wall Street analysts at the big investment firms — and taking an average. A service, called Estimize.com, broadens the number of people whose opinion can be factored into the estimate. Estimize.com allows you to see what other investors think a company’s profit will be in the future — and even guess yourself. It’ll be interesting to see how such crowdsourced earnings estimates fare over the long term.
Pro forma earnings can be helpful when you’re trying to see whether a company’s earnings beat, matched, or missed earnings estimates. But pro forma earnings can also be abused by companies. By not following GAAP, companies have great leeway in adding certain one-time gains and ignoring charges they’d rather you not see. The Securities and Exchange Commission in 2002, for instance, said Trump Hotels & Casino Resorts departed from accounting rules and gave a misleading impression the company beat estimates when it reported quarterly results in October 1999. While the company told investors it was leaving out a one-time $81.4 million charge, it didn’t disclose that it also added a one-time gain of $17.2 million to its results. Investors assumed the company beat estimates due to strong performance, the SEC said, when in fact, Trump’s numbers were lifted by the gain.