Last week’s post had a simple explanation about the income statement and why it is important for investors. This part 2 is intended to expand on that, to explain more about the helpful income statement ratios and provide a line-by-line breakdown of this financial statement.
Like I said before, the income statement is one of 3 important financial documents that each publicly traded company is required to file. These are:
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement
What’s important to realize is that the balance sheet makes for a great LONG TERM indicator of company health, while the income statement publicizes the SHORT TERM health of a business. Ideally, I only invest in stocks with great financials in both of these. Finally, the cash flow statement explains what happens to excess cash that was made in the short term and where it exactly goes.
Income Statement Breakdown
Let’s now look at an example income statement from a real company, and I’ll go through a detailed line-by-line analysis. After reading this you should be able to take any income statement from a company’s 10-k and understand what the numbers are saying.
You’ll notice I took a very well known company, Facebook (FB), as our poster child for today. The stock has been a “hot stock” as of late and found a lot of momentum after a rocky IPO. You’ll see later why I’m not so impressed with their income statement. But for now, let’s go through each row.
-Revenue: This number is also referred to as sales. This number is strictly how much money went into a business through sales any given fiscal year. This DOES NOT include expenses, just strictly sales numbers.
-Costs and Expenses: I hope this one is self explanatory. This is what it costs to run the business, from the people to the manufacturing to the parts and more. In Facebook’s case, this would be server costs, engineer costs, advertising costs, etc.
-Income from operations: This number is simply derived from the above two, just take the revenue number and subtract the costs and expenses number to get income from operations. Revenue – Costs and Expenses = Income from operations.
-Net Income: This is the final income that a company actually has. What happens in between income from operations and net income is that interest from investments (or expenses) are taken into consideration, along with an estimation on the income tax hit. You can see this clearly in the sub categories, and this is why net income isn’t just simply revenue – costs and expenses.
If you read my piece on balance sheets already, you’ll know that insurance companies are able to utilize investments substantially in order to pad their bottom lines, much more so than the average company.
-Net Income attributable to Class A and Class B common shareholders: You don’t always see the distinction between net income and net income attributable to shareholders. If there is no such distinction, you can assume that the net income numbers is the correct value for shareholders.
In the case of Facebook, they make this distinction and so you want to use the “attributable to shareholders” number for your income statement ratio calculations (more on this below).
–Earnings per share: This is a quite simple calculation: Net Income / Shares outstanding. The possible confusion comes in the difference between basic and diluted. Let me explain it as simply as I can.
It’s very common for companies to use stock options as a form of compensation for executives, and even sometimes for regular employees. The thing is, these options aren’t always cashed. When they are cashed, they dilute the shares, because they add to the total share count.
However, these options don’t affect a company’s financials if they aren’t cashed. So how is a company to account for any outstanding stock options?
That’s where basic and diluted come in. The “basic” number is calculated without taking into consideration any outstanding stock options. The “diluted” number presents the worst case scenario, if all of the stock options were cashed immediately.
Now what I do is to always evaluate companies (their EPS and shares outstanding numbers) with their diluted numbers. It just doesn’t make sense to use basic EPS or shares outstanding… you can’t just ignore the stock options! Besides, they will be cashed eventually, so you might as well account for it now.
-Weighted Average Shares: Also known as “shares outstanding”, and is simply the number of shares that are out to represent ownership of the company.
Example, if a business had 100 shares outstanding, I’d only need to own 1 share to own 1% of it. 51 shares would be 51% ownership and thus control of the company (due to voting rights). As you can see, public corporations are enormous entities with millions of possible shareholders and owners.
-Share based compensation expense included in costs and expenses: Like the title says, this category was already included in the costs and expenses section. Therefore, we don’t need to worry about this. Most of the time the income statement doesn’t even include this part, so I can safely say you don’t need to worry about it.
Income Statement Ratios
Now that the income statement breakdown is complete, let’s move on to the income statement ratios. I go over these same ratios in depth in part 1, where I explain their importance in layman’s terms.
The only 2 ratios you need to learn about for the income statement are price to sales (P/S), and price to earnings (P/E). Basically these ratios tell you how much you are paying for a stock’s earnings and revenue.
You really don’t want to overpay for a stock’s earnings. After all, the higher you pay for a stock’s earnings, the more you need a stock to over-perform on expectations in order to return you good money. Same goes with sales. A stock may have great earnings one or two years out of ten, and if you are focused solely on earnings you could get caught in what’s only temporary good fortune.
The more you learn about fundamental analysis of stocks, the more you’ll realize that there isn’t just one perfect ratio, be that an income statement ratio, balance sheet ratio, or other. In fact, using just one ratio to analyze a company will lead you to a world of hurt. I’ve always taught to look at 7 important categories (called my 7 Steps). P/S and P/E are two of them.
To calculate these income statement ratios, use the following:
Price to Sales (P/S Ratio) = Price / Sales
Price to Sales (P/S Ratio) = [Stock Price * Shares Outstanding] / [Revenue]
Price to Sales (P/S Ratio) = [Market Capitalization] / [Revenue]
Price to Earnings (P/E Ratio) = Price / Earnings
Price to Earnings (P/E) = [Stock Price * Shares Outstanding] / [Net Income]
Price to Earnings (P/E) = [Market Capitalization] / [Net Income]
That’s it. Remember, check with Pt. 1 of this post if you really want the nitty gritty behind why these ratios are important. I really go in depth with my explanation, but keep it simple at the same time.
No Advanced Degree Needed
As you can see, this whole income statement breakdown was done without the use of an advanced finance degree or special dictionary. Yes it takes a little patience and time to sort through it all, but in the end the income statement makes sense intuitively.
I’m hoping that this breakdown inspires you to look at other parts of a financial statement without fear. It’s worded with big, scary words intentionally to try and scare people off. The investment advice community thrives off of people’s fear of financial statements.
Naturally, an industry like finance will produce jargon that is hard to understand. I’m not going to argue against that. I’m also not saying this stuff is easy. But I’m hoping to prove a point that you can understand anything you set your mind too.
Great investing is not complicated. The concepts are as simple as the words profit and debt, and really in the end it just comes down to those simple things.
All these big words are trying to tell you the same story. Learn them, and you can recognize just how to find the companies that will feed you with profit.. year after year after year.
**Pt. 2: Income Statement Ratios and Breakdown**
**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