Income statements can surprise investors

March 15, 2016

[updates: 3/18/2016, 3/28/16 addition of the ‘customer-derived profit’ concept of EBIT]

No other report of profit exerts greater influence on the Stock Market than that of a company’s net income. Why? Stock analysts make predictions of future net income that influence the decisions of investors.  Eventual announcements of actual net income may be very pleasing or disappointing news to investors who then generate a surge of trading in the market place.

The company’s only sources of income are customers, investments, and investors.  For an established company, customers are the preferred source of profit!  Operating income (a.k.a. EBIT) is the profit earned from customers.  The adjustment of EBIT by extra items yields net income.  Net income (a.k.a. Earnings, EPS) represents the profit that a company can share with its stock holders. Market regulators require companies to reveal the operating income and net income in quarterly and annual income statements.

Income statements are designed to reveal how business operations generate net income. The purpose of this article is to describe the income statement of companies outside the banking and insurance industries. Hopefully this article will help you perform a fundamental analysis of most companies listed in the stock market.

Structure

The Income Statement is one of 3 financial statements that companies report to investors on a quarterly and annual basis. Accountants prepare the statement by consolidating all of the company’s non-cash transactions into a standardized ledger that measures the business operations used to earn a profit. Chart 1 shows the main elements of an income statement:

incomestatement

Chart 1

Total Revenues are also called the top line of the income statement. They measure the net sales of all products. Operating expenses are used to acquire, sell, and distribute the products. Extra items are additional transactions that don’t generate sales, but increase or reduce the profit from sales. Net income is also called the bottom line of the company. Net income is the profit that a company can share with its stock holders.

Relevant information

In my opinion, the “LINE ITEM” column in Table 1 lists the income statement’s most relevant information for individual investors. The “$” column shows the relevant measurement in units of U.S. dollars. The “% OF SALES” and “PROFIT MARGIN” columns display convenient ways of analyzing the income statement. At the time of this writing, I collected the “$” and “% OF SALES” data from a company’s ‘financials’ tab in morningstar.com. I simply toggled the statement’s ‘view’ command to switch from $ to %.

mainitems

Table 1.

“Revenue” (a.k.a. Total revenues, Sales) is the total value of all products shipped to customers during the reporting period. The revenue is usually recorded at the time of delivery before any cash payment is made by the customer. “Gross profit” is the remaining revenue after deducting all costs of production from the Sales. “Operating income” is the remaining revenue after deducting all other expenses of operating the business from the gross profit. “Income before taxes” is the remaining revenue after adjusting the operating income available to pay taxes. Net income is the company’s earnings after the revenue is reduced by all operating expenses and extra items.

There are several line items of net income listed in every income statement.

  • “Net income available to common shareholders” represents the residual net income after payments of dividends to the company’s preferred shareholders.
  • “Diluted Earnings per share” (EPS) is the portion of “net income income available to common shareholders” divided by diluted shares. Diluted shares are all outstanding shares (“basic shares”) plus the potential gain of shares from convertible securities.

Fundamental analysis of profitability

Profit margins are percentages of Revenue that represent intermediate and final profits. The profit margins in Table 1 measure the impact of production, operating expenses, and extra items on the company’s sales. Here are the units of measurement:

  • Gross margin = 100 * Gross profit / Revenue = 41.3% = 43.1 cents of every sales dollar.
  • Operating margin = 100 * Operating income / Revenue = 22.4 % = 22.4 cents of every sales dollar.
  • Net margin = 100 * Net income / Revenue = 14.2% = 14.2 cents of every sales dollar.

In table 1, the gross margin reveals that after paying all costs of production, the company is left with 43.1 cents from every dollar of revenue to pay for the remaining operating expenses. Costs of production include all expenses of manufacturing goods and providing services. The manufacturing process requires equipment, labor, and basic materials to build an inventory of finished goods. The provision of services requires labor and equipment. A company can be more profitable by reducing its costs of production.

The operating margin (Table 1) represents a residual revenue of 22.4 cents per sales dollar after paying all costs of production plus the costs of maintaining the business and selling the product. Think of the operating margin as customer-derived profit.  A company can earn more profit from its customers by cutting some of its operating expenses.

Net income is the remaining profit after paying operating expenses and adjusting for extra items such as government taxes. In table 1, the net margin is 14.2 cents for every dollar of revenue. The company could be more profitable by cutting some of its expenses or earning extra income. The net income is available to reward share holders in a variety of ways that eventually translate into capital gains and possibly dividends. For example, the earnings per share (a derivative of the net income) enables thousands of stock market participants to place a value on each share of ownership in the company. An increase in market value would allow stockholders to sell their shares for a capital gain.

Fundamental analysis of the competition

The business performance of 2 or more companies in the same industry can be compared by assessing their profit margins. Table 2 provides an hypothetical example of how 2 competitors manage their business revenue. For every sales dollar, company A is less profitable than company B as revealed by A’s lower profit margins. Why is B more profitable? Its 66% gross margin reflects a lower cost of production that ultimately generates a higher net margin of 24%. Game over!

Table 2.

Table 2.

Notice that company A is more efficient at maintaining its business and selling its product. Company A’s 19 percentage-point difference between 41% and 22% is less than company B’s 33 percentage-point difference between 66% and 33%. For every dollar of sales, Company A was better at squeezing some profit from its customers with lower maintenance and sales costs. Also notice that the impact of extra items (e.g. potential taxes) was nearly the same for both companies; 8 percentage-point versus 9 percentage-point differences between the operating and net margins.

Conclusions

Income statements report a set of measurements that investors can use to analyze a company’s business operations and its ability to earn a profit. The company’s operating income (‘EBIT’) and net income (‘EPS’) are the key elements of an income statement.  Operating income is used to calculate the operating margin, which measures how much profit the company earns out of every sales dollar from its customers.  The net income  depends on total revenue and efficient management.  For every dollar of revenue, the company that operates more efficiently has a better chance of earning a net income as measured in separate ways by the net margin and EPS.  The company’s earnings per share (EPS) represent the profit that the company can share with its stock holders. There are several ways to increase the EPS: boost sales, trim costs, retrieve shares, and seek extra income.

Copyright © 2016 Douglas R. Knight


What is a good growth stock?

December 22, 2015

Theme

—profitable companies attract investors—

A good growth stock represents the profitable company that sells desirable products. The company’s business earnings should grow nearly 6% annually so as to match the growth rate of the U.S. Economy (about 3.5%) and compensate the rate of U.S.Inflation (about 2%); otherwise, the company might do well to liquidate its business and reinvest in securities.

Growth stock investors seek an annual rate of return that exceeds the U.S. Stock Market’s historical 8-10% annual rate of return. The basic approach is to buy stocks at a low price and sell them at a high price, but that is easier said than done. Investors can help realize high returns by selecting stocks from well managed companies, holding the stocks through an adequate growth period, to offset price volatility, and diversifying their stock portfolio.

Evaluating the company

Does the company earn respectable profits with a sustainable business? The answer is yes if the company has a:

  • growth rate of earnings that surpasses 6% annually.
  • future growth rate of earnings that surpasses 6% annually.
  • durable business with a sustainable growth rate.

Growth rate. The company that recognizes and satisfies the needs of customers will accumulate sales with the demand for its product. Profitability is the combination of sales growth coupled with efficient management of business expenses. In other words, the profitable company has a respectable growth rate of sales with respect to time, respectable rate of earnings with respect to sales, and consequently, a respectable growth rate of earnings with respect to time.

Earnings are the net income from sales after payment of expenses. The growth rate of earnings matches the growth rate of sales when the company runs its business in a consistent manner. Both sales and earnings should grow annually by at least 6% to outperform the national economy and compensate for the effect of inflation. Growth investors typically monitor the company’s earnings per share (EPS) on a quarterly basis. The EPS should grow at a compound annual growth rate of 6%, or more, as determined from at least 5 years of historical data. When evaluating a company’s earnings, consider the possibility that management is manipulating the EPS to earn higher compensation.

Future growth rate. The earnings estimate is an analyst’s quarterly or annual forecast of the EPS. The estimate is more uncertain when the forecast extends to 3-5 years. Investors use the earnings estimate to track a company’s performance and to derive a future range of share prices. The growth investor should seek companies with earnings estimates above the 6% compound annual growth rate.

Durable business. Any company can be driven out of business by an economic disaster in the entire industry, strong competition, and a declining market for the company’s product. The durable company has sufficient financial strength to survive hard times coupled with the competitive advantages needed to maintain its market position. The sustainable growth rate is a measure of the company’s capacity for earnings growth, assuming there’s room for growth of sales in the product’s market. An analysis of market opportunity is used to estimate the future demand for the company’s product.

Evaluating the stock

If a profitable company attracts investors, its stock price will rise with investors’ demand for shares. The attractive stock may be detected by a:

  • favorable valuation
  • price momentum
  • projected annual return above 10%

Favorable valuation. Growth investors place a high value on the company’s EPS for the simple reason that EPS represents the net income that generates an investment return. The 2 sources of investment return are dividends and capital gains. If the company choses to pay dividends, they are derived from the net income. Capital gains are the amount of profit from an increase in share price generated by investor-demand.

The price of a growth-stock tends to increase with the rise in EPS. This relationship is measured by the price-to-earnings ratio (P/E or PE). The current P/E is today’s price divided by the EPS of the past 12 months. The current P/E reveals what investors are willing to pay for each dollar of company earnings. The relative P/E is a ratio of the current P/E to past P/Es or to some benchmark P/E such as the average P/E of the stock market. At parity, the relative P/E is 1.0. Stocks below parity are undervalued by market participants and may be trading at prices that favor buyers. Conversely, stocks above parity are overvalued and may be trading at prices that favor sellers. There are other ways of assessing the value of a stock such as the calculation of fair value performed by stock analysts.

Price momentum. Another characteristic of the growth stock is that its share price is likely to continue in the direction of an upward trend as long as there’s a demand for shares. A review of historical prices will reveal the direction of price momentum.

Projected annual return. The reason that growth investors should seek returns above the 8%-10% total return of the stock market is that an alternative investment in index funds will capture the market’s return. One way of projecting the stock’s annual return is to multiply the future EPS by a P/E ratio to obtain the future share price. The difference from today’s price represents the future capital gain. Factoring in the stock’s dividend yield will give the projected annual return.

Risk management

The primary hazards of incurring a loss are,

  • company risk
  • market risk
  • portfolio risk

Company risk. Poor management can weaken the company and reduce its profitability. A fundamental analysis of the company, which includes a review of the financial statements, can help reduce the possibility of investing in a poorly managed company. Periodic reviews of financial statements and company news are needed to reassess the company’s management efficiency and help prevent a serious capital loss from investment.

Market risk. Volatility is the moment-to-moment fluctuation in share price that results from trading activity in the stock market. Greater volatility produces greater upside and downside risks. Upside risk is the potential gain from an investment. It represents a reasoned guess of the future peak share price. Downside risk is the potential loss. Volatility, upside risk, and downside risk are calculated in several ways. Generally speaking, riskier investments should be held for longer time periods to improve the chance of earning an estimated return.

Portfolio risk. A concentrated portfolio has a large investment in one stock compared to others. Any capital loss from the largest holding could seriously degrade the investment return of the whole portfolio. The potential impact of capital loss from a large investment can be reduced by re-allocating the principal among stocks that are diversified with respect to industry and company size.

Conclusions

A good growth stock outperforms the stock market because the company’s earnings grow faster than the Economy. One way detecting a good growth stock is to find the company that has a good sales record, bright future for earnings, and durability. Then determine what value other investors place on the stock in today’s market and future years. A potential capital gain of 10% or higher is a good growth investment.

Copyright © 2015 Douglas R. Knight


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