Stock Investing: Fundamental Analysis Using Company’s Income Statement
Ever wondered how much money do companies like Facebook, Google, Amazon, Apple, Netflix, IBM bring in, how much money do they spend to operate and how much profits do they generate? In this article, I will explain how you, as an investor, can make use of an important financial statement called an income statement to get an insight into the company’s profitability. As I mentioned in my previous article on fundamental analysis using key ratios, we always want to find good stable businesses generating consistent growing profits which we can hold for the long term.
I will touch upon all key parts that make up an income statement, what does it mean when financial experts talk about “top-line and bottom-line revenue” and help you understand the different types of profit margins.
Key parts of an income statement:
Lets understand the key parts of an income statement with an example. In fig.1 below, I use the income statement of International Business Machines Corporation (Ticker: IBM) for the years 2013–17.
- Revenue: Sometimes referred to as “top-line”, revenue refers to how much money the company brought in by selling goods and services. As fig.1 indicates, in 2017, IBM had a revenue of $79,139 million.
- Cost of goods sold: This 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. For instance, for a car manufacturing company, the cost of goods sold might include the cost of steel used to build the car. As shown in fig.1, in 2017, IBM had cost of goods sold worth $42,913 million.
- Operating expenses: These are indirect expenses, incurred by the companies as they conduct business, but may not go directly into the product. Operating expenses may include: marketing expenses, research and development or administrative expenses. As fig.1 indicates, in 2017, IBM had operating expenses worth $24,427 million.
- Other income: This measures how much money a company brought in for things other than selling goods and services. For instance, a company might sell a factory or win a legal settlement. As shown in fig.1, IBM earned $216 million in other income in 2017.
- Other expenses: Other expenses might include the cost to restructure a unit of the company, paying severance to lay off employees, or depreciation.
- Earnings before interest and taxes (EBIT): This is what you are left with after you subtract cost of goods sold, operating expenses, and other expenses from revenue. Often referred to as EBIT.
- Earnings before interest, taxes, depreciation and amortization (EBITDA): EBITDA calculates earnings before any depreciation or amortization is determined. EBITDA is popular among highly leveraged and capital-intensive firms that require lots of depreciation calculations, such as utilities or telecommunications companies. This is because these firms have high depreciation rates and large interest payments on debt, often leaving them with negative earnings. As fig.1 indicates, in 2017, IBM has an EBITDA of $16,556 million.
- Interest expenses: Most companies borrow money (i.e. issue debt) to fund their operations or to buy inventory. These expenses measure the how much the company is paying to borrow money. As fig.1 indicates, IBM had interest expenses worth $615 million in 2017.
- Taxes: This is a measure of taxes paid by the company. For companies that make a profit, taxes are an expense on the income statement.
- Net income: After paying all costs and expenses, what’s left is the profit, or net income. This is a measure of how much the company earned during the period. As fig.1 indicates, IBM had a net income of $5,753 million in 2017.
Taking in the Top Line: Revenue
Revenue is a critical item because it tells you how rapidly the company is growing (or shrinking), how strong demand is for company’s products and how a company ranks in size next to its rivals.
Breaking down a company’s revenue
Due to its large size and wide array of technology businesses, IBM is a good example of how you can use the revenue line to peer deeply into a company’s operations.
Dissecting IBM’s revenue into units helps you understand that, although, the company’s business is diversified, in 2017, majority of IBM’s revenue came from Technology Services and Cloud Platforms as you can see in figure 2. It also gives you an indication of the most important business of IBM.
Tip: 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.
Therefore, in our case, divide the Technology Services and Cloud Platforms revenue of $34,277 million by IBM’s total revenue of $79,139 million to arrive at 0.433. Multiply 0.433 by 100 to convert the result into a percentage of 43.3%. This means the Technology Services and Cloud Platform business unit contributed to 43.3% of IBM’s total revenue in 2017.
Keeping tabs on a company’s growth
As an investor, you always want to see revenue increasing over time so the company’s earnings keep up with inflation. Lets understand how to find year-over-year percentage growth/decline in revenue for IBM:
IBM’s 2017 revenue growth/decline: $79,139 Mil.(2017 revenue) — $79,919 Mil. (2016 revenue) / $79,919 Mil.(2016 revenue) = -0.009. Then multiply 0.009 by 100 to convert the number into a percentage, which is -0.9%. This analysis shows you IBM’s total revenue declined by 0.9% in 2017.
Tip: Subtract the “old” number from the “new” number, then divide by the “old” number and multiply by 100.
Note: You can perform similar calculations for 3-year, 5-year or 10-year to understanding the trends in company’s revenue growth. It will also help you understand whether the company’s business is cyclical. A cyclical company is one that experiences large swings in revenue based on the health of the overall economy.
Digging into company’s costs
A commonly used technique called as common sizing, can be used to easily see whether the company’s expenses are growing at an alarming pace compared with the growth of the business.
Tip: To perform common sizing, 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.
In our case, in 2017, IBM’s Sales, General & Administrative (SG&A) expenses accounted for $19,555 Mil. / $79,139 Mil. * 100 = 24.7% of total revenue. Note: You can also perform year-over-year calculations like we did for company’s revenue growth for 3, 5 or 10 years.
Tip: It is better to use several years of data while performing common-sizing so that you can identify a trend. For instance, if a company’s research and development budget is soaring, you’ll spot the trend.
What is the company’s bottom line or profit?
After paying all the bills, including all the direct costs, operating expenses and taxes, what’s left is the company’s net profit. It is sometimes referred to as a company’s “bottom line”. This tells you how a company did compared with the past and versus expectations investors had. As an investor, you will want to see how rapidly net income grew or shrunk compared with previous years.
Net income = Revenue — cost of goods sold — operating expenses+other income — other expenses — interest expense — taxes
Tip: Though net income is important, it should not be thought of as the end-all, be-all figure to focus on.
Types of Profit Margins
One of the best ways to measure 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.
- Gross Profit Margin: A company’s gross profit, also called gross margin, is what’s left of revenue after subtracting direct costs, also known as cost of goods sold. It measures how much the company makes after paying costs directly connected with producing the product.
- Operating Profit: Also called as operating margin, 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.
- Net Profit Margin: A company’s net profit, net margin, or net income, is the most comprehensive measure of profitability and tells you how much money the company keeps after paying all its costs and expenses. At its simplest level, net profit is operating profit minus everything else.
Earnings Per Share (EPS): Most commonly known as EPS, it is calculated by dividing net income by the number of shares outstanding at the company. If net income tells you how large a pie is, EPS tells you how big your slice is.
You’ll notice that two EPS calculations are performed on the income statement: one for basic EPS and the other for diluted EPS. The difference is in the way the number of shares outstanding is used.
- Basic earnings per share: This measure tells you 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. As fig.1 indicates, IBM had a basic EPS of 6.17.
- 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. 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. Note: Diluted EPS is almost always less than basic EPS. As fig.1 indicates, IBM had a diluted EPS of 6.14.
Tip: Using diluted shares is much more informative than using basic shares, because if and when securities such as stock options issued to employees and convertible bonds, are converted into shares of common stock, your stake in the company, or your piece of the total pie, gets smaller and smaller.
With the ability to analyze an income statement, you should get some sense as to how profitable a company actually is, a key consideration in deciding whether or not to become an investor in that company.
Stay tuned for my next article where I will discuss about how to analyze a company’s financial health by understanding the company’s balance sheet.
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The content in the above article is for information and educational purposes only. It is not intended to be an investment advice. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed professional for investment advice.
Other articles by me
- Fundamental Analysis Using Key Ratios: https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-key-ratios-ed02f32e88ae
Amrut is a Full Stack Software Engineer who is passionate about tech and software development in Web and Mobile. He likes to write about coding, investing, finance and neuroeconomics. He strongly believes in adding value to people’s life through quality work. He also loves to watch and discuss about American Football.