What should I look at in the Income Statement?The famous value investor, Mohnish Pabrai , said in one of his lectures that when he visited Warren Buffett, he noticed a huge handbook with the financial statements of thousands of public companies. It's a very dull reading, isn't it? Indeed, if you focus on every statement item - you'll waste a lot of time and sooner or later fall asleep. However, if you look at the large volumes of information from the perspective of an intelligent investor, you can find great interest in the process. It is wise to identify for yourself the most important statement items and monitor them in retrospect (from quarter to quarter).
In previous posts, we've broken down the major items on the Income statement and the EPS metric:
Part 1: The Income statement: the place where profit lives
Part 2: My precious-s-s-s EPS
Let's now highlight the items that interest me first. These are:
- Total revenue
The growth of revenue shows that the company is doing a good job of marketing the product, it is in high demand, and the business is increasing its scale.
- Gross profit
This profit is identical to the concept of margin. Therefore, an increase in gross profit indicates an increase in the margin of the business, i.e. its profitability.
- Operating expenses
This item is a good demonstration of how the management team is dealing with cost reductions. If operating expenses are relatively low and decreasing while revenue is increasing, that's terrific work by management, and you can give it top marks.
- Interest expense
Interest on debts should not consume a company's profits, otherwise, it will not work for the shareholders, but for the banks. Therefore, this item should also be closely monitored.
- Net income
It's simple here. If a company does not make a profit for its shareholders, they will dump its shares*.
*Now, of course, you can dispute with me and give the example of, let's say, Tesla shares. There was a time when they were rising, even when the company was making losses. Indeed, Elon Musk's charisma and grand plans did the trick - investors bought the company's stock at any price. You could say that our partner Mr. Market was truly crazy at the time. I'm sure you can find quite a few such examples. All such cases exist because investors believe in future profits and don't see current ones. However, it is important to remember that sooner or later Mr. Market sobers up, the hype around the company goes away, and its losses stay with you.
- EPS Diluted
You could say it's the money the company earns per common share.
So, I'm finishing up a series of posts related to the Income statement. This statement shows how much the company earns and how much it spends over a period (quarter or year). We've also identified the items that you should definitely watch out for in this report.
That's all for today. In the next post, we will break down the last of the three financial statements of a public company - the Cash Flow Statement.
Goodbye and see you later!
EPS
My precious-s-s-s EPSIn the previous post , we began looking at the Income statement that the company publishes for each quarter and year. The report contains important information about different types of profits : gross profit, operating income, pretax income, and net income. Net income can serve both as a source of further investment in the business and as a source of dividend payments to shareholders (of course, if a majority of shareholders vote to pay dividends).
Now let's break down the types of stock on which dividends can be paid. There are only two: preferred stock and common stock . We know from my earlier post that a stock gives you the right to vote at a general meeting of shareholders, the right to receive dividends if the majority voted for them, and the right to part of the bankrupt company's assets if something is left after paying all debts to creditors.
So, this is all about common stock. But sometimes a company, along with its common stock, also issues so-called preferred stock.
What advantages do they have over common stock?
- They give priority rights to receive dividends. That is, if shareholders have decided to pay dividends, the owners of preferred shares must receive dividends, but the owners of common shares may be deprived because of the same decision of the shareholders.
- The company may provide for a fixed amount of dividend on preferred shares. That is, if the decision was made to pay a dividend, preferred stockholders will receive the fixed dividend that the company established when it issued the shares.
- If the company goes bankrupt, the assets that remain after the debts are paid are distributed to the preferred shareholders first, and then to the common shareholders.
In exchange for these privileges, the owners of such shares do not have the right to vote at the general meeting of shareholders. It should be said that preferred shares are not often issued, but they do exist in some companies. The specific rights of shareholders of preferred shares are prescribed in the founding documents of the company.
Now back to the income statement. Earlier we looked at the concept of net income. Since most investments are made in common stock, it would be useful to know what net income would remain if dividends were paid on preferred stock (I remind you: this depends on the decision of the majority of common stockholders). To do this, the income statement has the following line item:
- Net income available to common stockholders (Net income available to common stockholders = Net income - Dividends on preferred stock)
When it is calculated, the amount of dividends on preferred stock is subtracted from net income. This is the profit that can be used to pay dividends on common stock. However, shareholders may decide not to pay dividends and use the profits to further develop and grow the company. If they do so, they are acting as true investors.
I recall the investing formula from my earlier post : give something now to get more in the future . And so it is here. Instead of deciding to spend profits on dividends now, shareholders may decide to invest profits in the business and get more dividends in the future.
Earnings per share or EPS is used to understand how much net income there is per share. EPS is calculated very simply. As you can guess, all you have to do is divide the net income for the common stock by its number:
- EPS ( Earnings per share = Net income for common stock / Number of common shares issued).
There is an even more accurate measure that I use in my analysis, which is EPS Diluted or Diluted earnings per share :
- EPS Diluted ( Diluted earnings per share = Net income for common stock / (Number of common shares issued + Issuer stock options, etc.)).
What does "diluted" earnings mean, and when does it occur?
For example, to incentivize management to work efficiently, company executives may be offered bonuses not in monetary terms, but in shares that the company will issue in the future. In such a case, the staff would be interested in the stock price increase and would put more effort into achieving profit growth. These additional issues are called Employee stock options (or ESO ). Because the amount of these stock bonuses is known in advance, we can calculate diluted earnings per share. To do so, we divide the profit not by the current number of common shares already issued, but by the current number plus possible additional issues. Thus, this indicator shows a more accurate earnings-per-share figure, taking into account all dilutive factors.
The value of EPS or EPS Diluted is so significant for investors that if it does not meet their expectations or, on the contrary, exceeds them, the market may experience significant fluctuations in the share price. Therefore, it is always important to keep an eye on the EPS value.
In TradingView the EPS indicator as well as its forecasted value can be seen by clicking on the E button next to the timeline.
We will continue to discuss this topic in the next publication. See you soon!
PER, PBR, ROE, EPS Explained for Beginner InvestorsLegendary stock investor Peter Lynch once said that there’s a reason why the majority of people make money in real estate, but not in the stock market.
People spend months on finding the right property, whereas in choosing the right stock to invest in, they only spend a few minutes.
In this post, I'll be explaining the concepts of:
1) Price Earnings Ratio (PER)
2) Price-to-book Ratio (PBR)
3) Return on Equity (ROE)
4) Earnings per Share (EPS)
by explaining the formula, what they tell us, and the best way to understand these concepts through an example.
Return on Equity (ROE)
So let’s start with the Return on Equity, or ROE.
This measures the profitability of a company in relation to stockholder’s equity.
The ROE is calculated by dividing the net income by the shareholder’s equity.
Price Earnings Ratio (PER)
Next, we have the price earnings ratio, or the PER.
This is a good tool to determine whether a company is overvalued.
The PER is calculated by dividing the current share price by earnings per share.
For instance, if a company’s share price is at $100, and their earnings per share is $10, this gives them a PER of 10.
Price-to-book Ratio (PBR)
Then, we take a look at the price to book-value ratio, or the PBR.
This measures the market’s valuation of a company relative to its book value, and is calculated by dividing the market price per share by the book value per share.
Earnings per Share (EPS)
Lastly, the EPS, or earnings per share.
This is simply the company’s profit divided by the outstanding number of shares outstanding, and works as a good indicator of how profitable a company is.
Example
- Let’s take a look at an example to help your understanding.
- You currently have $100,000, and you decide to open a restaurant.
- You are required to pay $100,000 in deposits, and $3,000 in monthly rent.
- You started this restaurant in the form of a limited liability company.
- You started the company with $100,000.
- Given that you issue shares that are worth $10, you issue 10,000 shares in total.
- A year later, you check how well your business has done.
- You find out that the restaurant did $300,000 in revenue, and after subtracting all costs, you’re left with $30,000.
- With this, you can calculate the return on equity by dividing 30,000 by 100,000, which gives you an ROE of 30%.
- Through the ROE, you look at how much return your own money was able to generate in profits.
- From the perspective of an investor, the higher the ROE, the better.
- You can also calculate the EPS, or earnings per share.
- In this case, the restaurant generates $30,000 in profits.
- So if we divide that by the number of shares, which is 10,000, we get an EPS of $3.
- Now let’s assume that you ran the business for 3 years, and you now want to sell your business to someone else, so you can move on to do other things.
- How much do you want to sell the restaurant for? After 3 years, you now have loyal customers, and it consistently generates $30,000 in profits every year.
- So, you decide to sell the restaurant for $200,000 in total, with a $100,000 premium on top of the deposit.
- If someone buys the restaurant for that price, it means that you and the other party agrees that the business is worth $200,000.
- Now if this restaurant is sold for $200,000, that means the $10 shares you hold are sold for $20.
- When we invest in stocks, this is how we make money.
- With all the information above, we can calculate the PER and PBR.
- If a restaurant that generates $30,000 in net profits gets sold for $200,000, the PER is 6.7.
- And then, we also have the PBR.
- You started the business with $100,000 of your own money, and sold it for $200,000, which gives you a PBR of 2
- For the PER and PBR, the lower the better.
- A low PER means that you are buying a company that generates a lot of net profit for a cheap price.
- Same for the PBR. The lower it is, the more undervalued it is.
Conclusion
The PER, PBR, ROE, and EPS can be great tools to help us identify whether a stock is a good buy or not. Understanding these concepts are imperative for beginner investors.
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