Income statement fundamentals
In this series, I’ll be discussing income statement fundamentals i.e. how to read an income statement and make meaning of it to guide you in deciding if a company is worth investing in and to answer the quintessential question: is the company making money and how?
Income statement items and presentation will vary by industry; however, there are standard yardstick measures such as net revenues, cost of sales, operating income (or loss), operating expenses, depreciation and amortization, income (or loss) before tax, income taxes and finally net income (loss). The expression ‘top line’ refers to revenues i.e. the top of the income statement while ‘bottom line’ refers to net income (loss) i.e. the bottom or end of the income statement. To derive any meaningful analysis of a company’s income statement, it is best to have at least 3 – 5 years worth of data in order to analyse the trend. Let’s pick at the income statement line by line over a 3 – 5 year period:
- Revenues: is there growth in this top line figure i.e. over the last 3 – 5 years, have revenues been increasing, flat or decreasing? If revenues have been shrinking, then it calls to question the sustainability of growth for that company
- Cost of sales (“COS”): in manufacturing companies, this is called ‘cost of goods sold’ and represents what it costs the company to produce the products sold. For service oriented companies, it could be ‘cost of sales’ i.e. what it costs the company to produce the services sold. It is possible for COS to increase every year especially as the company grows; however; it is important to see a reduction in the COS margin i.e. the ratio of COS to revenues.
- Operating expenses (“opex”): also referred to as selling, general and administration expenses. These are costs that pertain to operating the company and promoting products and services. Examples are salaries & benefits, marketing costs, advertising, office rent, utilities, sales commissions etc. Operating expenses should be watched closely. It is possible for opex to increase year over year especially as the company grows; however, it should be watched keenly especially if the opex margin i.e. the ratio of each opex item to revenues is increasing.
- Other expenses such as depreciation, amortization, interest income / expense and other non-core income and expense finish out the income statement to arrive at income before taxes
- Taxes are computed using the company’s effective tax rate. Companies have to pay their dues to Uncle Sam
- Finally comes the bottom line: net income (or loss)
Making sense of an income statement
When you take total revenues and subtract out COS, it results in gross profit amount. Again, for trend analysis, you should compute the gross margin i.e. total gross profit as a ratio to total revenues. E.g. if Company XYZ had total revenues of $20 million and COS of $14 million, then gross profit is $20M – $14M = $6M. Gross profit % is 6M / 20M = 30%. What’s the trend looking like — increasing? flat? or decreasing? is it lumpy year over year? Is 30% a good gross margin?
Another important metric is the opex margin which is total opex as a ratio to total revenues. And finally, you have net income margin i.e. net income as a ratio to total revenues. Notice how total revenues become the reference point; an important factor as it provides a constant base on which to perform meaningful trend analysis year over year.
Once you have all your margin calculations done for the 3 – 5 year period for a particular company, the next step is to compare such margins or ratios to similar companies in the same industry, otherwise your analysis is meaningless. I asked earlier if a 30% gross margin was good, it may be, however, if 80% of other companies in the same industry regularly post gross margins north of 45%, then of a sudden, the 30% gross margin company doesn’t look attractive anymore given the results of its peers.
There are 3 ratios industry-sector analysts often harp on:
- Earnings per share (“EPS”): For publicly traded companies, this refers to net income divided by the number of shares / common stock outstanding in any given timeframe. EPS is one of the most important indications of a company’s current state. Ideally, analysts like to see increasing EPS levels year over year
- Price-to-earnings ratio (“P/E”): This is really a measure of price per share divided by earnings per share i.e. to determine whether you are getting a bargain by buying into this company. If the P/E is low, then it means the company may be undervalued in the market place and as such, this is a bargain. Here, as with previous caution, you should compare your company’s P/E to peers in the industry
- Understanding the nuances of a company is a very dynamic process. Another useful measure is price/earnings to growth ratio (“PEG”), which tries to account for future growth in EPS of a company and is a widely used measure of valuation. If Company A has a P/E of 60 and Company B has a P/E of 6, does it mean Company B is overpriced and A is a bargain? Not necessarily and that’s where PEG comes in handy. It is calculated by taking the P/E ratio and dividing it by the annual EPS growth rate (to level out the playing field for a more apples-to-apples comparison amongst companies). A PEG of 1 suggests the stock is fairly valued; greater than 1 suggest it may be over-valued and less than 1 suggest it may be under-valued.
The above may appear daunting at first, but I promise, once you invest some time to conducting the above analysis, to understanding the revenue and cost drivers of a company and if a company is worth investing in, the more adept you will become at performing income statement analysis seamlessly.