Last week I taught you about the importance of balance sheets, and now it’s time to shift gears into income statement analysis. The income statement is also called the “consolidated statements of operations” or “consolidated statements of income” in the official annual report. It’s also loosely referred to as the P&L in the corporate world, or the “profit and loss” sheet.
The income statement is a crucial part of analyzing a stock. Even if a company has a solid balance sheet doesn’t mean you can automatically invest and figure to be successful. The company must also be currently profitable if you want a good chance at continued success. Just look at any stock that used to be strong and then went bankrupt, it happens all the time when a company’s main product becomes obsolete. What you’ll see is that the lack of sales will affect the income statement first, and then eventually carry over to the balance sheet. You don’t want to wait around and have to endure the damage.
Now there are just two crucial numbers that we must take a look at for income statement analysis: net sales (also called revenue) and net earnings (also called net profit). Both tell us a story about how the company is doing.
Net earnings is #1. This is what makes Wall Street go ‘round. Don’t let anybody tell you otherwise, but at the end of the day net earnings determines success or failure. Sure there are times when the market becomes irrational and puts less emphasis on earnings, and this is usually a good indicator that the market is about to crash.
Net earnings are so important because without them, companies couldn’t pay shareholders. Sure they could issue some short term debt, but they wouldn’t be able to pay shareholders consistently without net earnings. Companies wouldn’t be able to reinvest in their own businesses without net earnings (again, in a sustainable way). Without payments to shareholders, shareholders have little incentive to take on so much risk. Thus, the whole concept of the stock market would collapse if companies didn’t have positive net earnings.
How the Statements Fit
If you look at the 3 financial statements (income, balance sheet, cash flow) and understand their relationships, you’ll better get how it all fits in. First is the P&L (income statement). Sales go in, expenses go out, and the remainder is the profit. The profit then shows up in the cash flow statement. It’s cash we have on hand. If that cash goes back to shareholders, or is used in any other way than buying assets, it gets deducted here. Finally, some of that cash is used to buy assets, reinvesting in the business and helping it grow. That’s when you’ll see it show up in the balance sheet. The balance sheet also accounts for any debts we’ve accrued as well.
So that’s how the 3 statements are all related. The P&L shows us how the company is doing RIGHT NOW, the balance sheet shows us the scorecard of the company LONG TERM, and the cash flow statement details where all the excess cash and profits are going.
The second crucial number of the income statement is net sales. While earnings are crucial, they can be unreliable from year to year. The truth is, you can manipulate earnings from a perfectly legal point of view just based on when you decide to account for certain expenses or revenues or other events. Sometimes these things fall in between years, and so earnings can be jumpy from year to year. Revenue numbers, on the other hand, are harder to manipulate are usually grow at a much steadier pace than earnings. Look at any income statement from several companies and you’ll see that this is the case. Another way of saying that is this: long term success will not happen to a company without a good long term trend of revenue growth.
You need to measure sales as much as you do earnings. Just like all things in investing, you can’t just rely on just one metric. Like with the balance sheet, the most important metrics are those that every single company shares and is required to submit into their annual reports by the SEC, and for the income statement that’s revenue and net earnings.
Now that we know the two most important numbers of the income statement, we must also learn the two important ratios that are drawn from these numbers. Any research with a sliver of credibility will at least consider the following: P/E ratio and P/S ratio.
Simple Business Example
Before I break down these ratios, let me explain why they are important. When you examine the stocks in the S&P 500, you’ll quickly discover that these companies operate in the hundreds of millions and billion dollar range. However, it’s not as simple as looking at the income statement and picking the stock with the bigger profit or revenue number.
You must understand that everything in the stock market must be compared relatively. For example, a small restaurant might be thrilled at a growth of $10,000 a year. They may be only making $20,000 a year, so a $10,000 a year growth would be 50%. Fantastic. However, to the large real estate business making $250,000 a year, $10,000 a year of growth is dismal. So you see it’s all relative, depending on the context.
In the same fashion, let’s say you had the option to buy either the small restaurant or the large real estate business. All things equal, I’d rather buy the large real estate business, obviously.. it’s making more money. But what if the real estate business is selling for $500,000, and the large restaurant is selling for $20,000? [remember the large business is making $250,000, while the small one is making $20,000] Now which one would you buy?
In this second scenario, I’d rather pay $20,000 to get $20,000 of profits a year rather than pay $500,000 to only get $250,000. This is a simplified example, so I’m sure you were able to make this easy calculation in your head. Yet it’s no different in the stock market! This is why we use ratios!
You see, the ratio you unconsciously calculated was just simply P/E ratio, or price to earnings. What you did was divide $20,000 by $20,000 to get 1, and $500,000 by $250,000 to get 2. So the small company is twice as cheap, and thus you are more likely to make twice as much of a return.
You can make simple calculations like this one to analyze companies in the stock market, it’s just at a much bigger scale and with more confusing words (like derivatives and depreciation).
Use the following two ratios to gain an understanding about the net profit and net sales numbers. By themselves, they don’t tell you much, but combined with balance sheet and cash flow numbers you can get the full picture.
[Caveat: Also keep in mind that these ratios will look different based on the industry a company is in. Comparing a company to its industry will give you a better picture than an outright comparison with another company. However this doesn’t make these numbers useless and industry comparisons won’t guarantee success. Just ask the typewriter industry investors how industry comparisons have fared. Industries may look different but they can’t break the laws of basic accounting common sense. Remember that whole industries can go bankrupt. ]
Income Statement Analysis
The first ratio is price to earnings, or P/E ratio. You simply calculate it like this:
P/E = [Market Capitalization] / [Net Earnings]
P/E = [Stock Price x Shares Outstanding] / [Net Earnings]
P/E = [Stock Price] / [Earnings per Share]
Generally, I look for stocks with at least a P/E below 25. I’d prefer stocks with a P/E below 15, and I really only go 15-25 if I’m getting a fantastic discount to book value.
What this does is keep you invested in very profitable companies, like our small and large business example above. By paying less for these earnings, we are basically improving our chances at greater returns.
The second important ratio has to do with net sales, and it’s called the price to sales ratio, or the P/S ratio. It’s as simple as this:
P/S = [Market Capitalization] / [Net Sales]
P/S = [Stock Price x Shares Outstanding] / [Net Sales]
For this ratio I want stocks with at least a P/S below 2, and a P/S below 1 if possible. This ratio isn’t as strict as the P/E ratio, and so the difference between a P/E of 15 and 25 is much greater than the difference between a P/S of 1 and 2. Obviously this is personal preference, but the P/S is more of a fail safe to prevent us from absurd valuations than it is a tool to find a great deal.
Believe it or not, there are actually companies that trade at 10x above sales, and more right now than ever. It that isn’t an indicator of a market top, I don’t know what is, but the general public never learns.
Before I get too sidetracked I just really want to emphasize the importance of these two ratios. Looking at the income statement is a great way to check the health of a company in the most purest and recent fashion. Put these ratios in your investing toolbelt, they will be extremely useful.
To get the rest of the essential investing toolbelt ratios, check out the ebook I wrote called the 7 Steps to Understanding the Stock Market. It’s free, and it gives you the whole picture.
**Simple Income Statement Analysis for Stocks**
**All Rights Reserved. Investing for Beginners 2014**
START FROM THE BEGINNING:
1. How to Read Annual Reports for Beginners
CONTINUE READING THE GUIDE:
2. Simple Balance Sheet Analysis
3. Line-by-Line Balance Sheet Breakdown
4. Simple Income Statement Analysis
5. Line-by-Line Income Statement Breakdown
6. Simple Cash Flow Statement Analysis
7. Line-by-Line Cash Flow Statement Breakdown