The price of a company’s stock is based in large measure on how well the company is likely to perform in the future. The balance sheet is a snapshot of a company's financial position, while the income statement shows a company’s operating activities for an entire period. The balance sheet tells you how financially sound a company is. The income statement answers the all-important question: "Are they making money?".
The income statement provides a solid foundation for forecasting the future profits of a firm. A single year’s results are not enough to do this forecasting, but most income statements already include three years of information. If you download the form 10-Ks from 2002 and 2005 from a source like www.freeedgar.com, you will get a full six years of data that can easily be imported into a spreadsheet.
The layout of an income statement is always similar among different companies, but can differ according to what business they are in. They will all start out at the top with the main source of income (which could be called things like "sales" or "gross revenue"). They then list other sources of income. Then the company begins to subtract out various itemized expenses. At the bottom, they show their final net income (or loss) for the year.
Below is an example of what the fiscal year 2003 income statement from Cisco Systems looked like after I loaded it into Excel:
As you can see, it’s really not that complicated for a $100 billion company. In many ways it’s not unlike the budget any typical household might put together. You list your income and then deduct things like taxes, insurance, rent, utilities, and other expenses. Anything left over is called profit (discretionary income in a household). Of course, the chances are the numbers on yours are probably not measured in millions as they are here.
Another big difference between a household budget and a company’s income statement is that the term "income" doesn't always refer to actual cash moving in and out. Households run on a “cash basis”. But most companies use the accrual rules of accounting. That means a firm can record income when it sells goods or services, regardless of when they actually get paid. It also means that company expenses are recorded at the time an asset is actually used. So even if the company paid $100,000 for an asset (machinery, for example) they write if off over a period of time such as $20,000 a year for five years.
The difference between cash and accrual accounting may seem a little technical. But it is important to know that a company would record only $20,000 as an expense each year instead of expensing the full $100,000 up front, because it implies that even a company with positive earnings on their income statement can go bankrupt if it doesn't have enough cash on hand to meet their day-to-day needs.
So now that we have all these numbers in a spreadsheet, what kind of fun can we have with them? The income statement is actually good for a couple of different things. If you have the past two years of balance sheets, you can see how changes were accounted for. For those with sufficient knowledge, they can even create (or double check) a company’s statement of cash flows.
More important is that you can use the numbers to help you judge the soundness of the business and the direction it is heading. The first thing I usually look at is the composition of income, often referred to as “quality of earnings”. Cisco breaks down net sales into product and services, with more than 80% of sales coming from the sale of actual equipment.
Services tend to offer a more stable source of income then selling products (things like routers in Cisco’s case). When the economy is bad, companies may not invest much additional money to expand into new businesses, or to upgrade their current equipment. But they will continue paying for the services that keep their current business up and running. Sales composed of 80% products means that Cisco is very exposed to the risk customers may stop buying for any reason.
Other than looking at the numbers themselves, I usually content myself with just four basic calculations, each of which I will go over in detail. The main things I look at are:
- Earnings Growth – Are earnings (per share) steadily increasing over time?
- Profit Margin – Are profit margins increasing? Declining margins a bad sign.
- Interest Coverage Ratio - 3 to 4 at least, although I prefer higher.
- P/E Ratio – Need to compare to industry or historical average, low is good.
The basic reason for an income statement is to show if the company made money or not. Positive earnings (otherwise known as a profit) are very important. It may be worthwhile to run a short-term loss if you are investing in expanded capacity or entering a new business or market. But in the long term costs must be less than income or you will go out of business.
Current earnings can give a good estimate of a firm's expected performance, and are also an important valuation parameter. The value of a company’s stock can be calculated as the present value of the firm. The present value of the overall firm is simply the company’s Book Value plus the present value of future earnings. The widespread coverage of earnings announcements in the media, and the change in stock prices after their release, shows that earnings are widely followed as measure of value.
The main problem with earnings in the short term, however, is that reported earnings at any given point in time tend to be “noisy”. They can be distorted by many factors, or manipulated by management. That is why it is better to see consistent growth of earnings over a long period of time, the longer the better, than one blow-out quarter.
The final thing I want to mention is that rather than simply looking at the absolute earnings number shown, it is better to look at earnings per share (EPS). EPS is calculated by taking total earnings and dividing by the number of shares outstanding. Companies that give out a lot of stock options to employees and others dilute the current stock holders ownership interest, and it’s possible for EPS to drop despite the company showing an increase in total earnings.
Profit margin is Net Income divided by Gross Revenue (or sales). The result you get from this calculation shows what percentage of each dollar received makes it to the bottom line as profit. Like many of the financial ratios, profit margin is most useful when used to compare companies in the same industry. It would tell you very little when trying to decide between GM and Microsoft. Without any calculations I can tell you Microsoft has a much higher profit margin.
It is also important to look at how a company’s profit margin has changed over time (say over a period of 5-6 years). Naturally, you would be more bullish on a company that has steadily grown its profit margin over time. What you don't want to see is a firm with steadily declining margins (unless you’re contemplating a bearish position, of course).
There are only two ways a company can increase their profit margin. In terms of the ratio itself, you can increase the numerator or decrease the denominator. For the numerator, that means a company can increase revenues. For the denominator, the company can cut costs. You would be especially bullish on companies that can increase revenue while cutting their costs at the same time.
Interest Coverage Ratio
Few things get investors more nervous than a company that can’t meet its financial obligations. Most stockholders buy for the long run and will hold on during the occasional bad quarter. Bondholders demand their regular payoff like clockwork, and they are very unforgiving if the checks stop coming in.
There are three major firms in the US (Standard and Poor's, Moody’s, and Fitch) that specialize in judging the credit worthiness of each company. They each assign a rating that is supposed to indicate the likelihood of a firm defaulting. Those who receive grades in the top tiers are often referred to as investment grade.
You can look at the income statement and check if a company can meet the demands of its creditors by calculating the interest coverage ratio. Simply find the earnings before interest and taxes (or EBIT) and then divide by their interest expense. This tells you how many times over they could meet their interest payments with current income.
Note: EBIT isn't always itemized on the income statement, but they will always list their pretax income. In Cisco’s above, it is titled: INCOME (LOSS) BEFORE PROVISION FOR (BENEFIT FROM) INCOME TAXES). You might be tempted to just divide pretax income by the current debt payment to get the interest coverage ratio. Don’t!
The government allows you to deduct interest expense from your taxable income, so any pretax income figure will have the current interest payments already taken out. You want to know “how many times over can I pay interest from current income" not “how many more times could I pay interest expenses from current income. So you need to add back the current interest expense to pretax income before doing this calculation.
The Cisco example above shows they have tons of cash (about $10 billion in cash, cash equivalents, and short-term investments) and no debt. So this question would not be of major importance in this case (unless of course you are comparing them to a heavily indebted rival). But most companies do have debt, and you would usually like to see that a firm can cover their interest charges at least three to four times over.
Very similar to the earnings per share we began with, the price-to-earnings ratio (P/E) is calculated by taking the current market price of the stock and dividing by its current EPS. It is used to compare stock prices on a relative basis, meaning that a $100 stock trading at a P/E of 8 is considered "cheaper" than a $20 stock with a P/E of 30.
You might then conclude that stocks with low P/E ratios are always better then high P/E issues. But that is not always true. Growth stocks usually deserve a higher multiple than those in mature industries because of higher expectations for future performance. It may also seem that low P/E stocks offer a type of safety net, since the market isn't expecting much from them in the first place. The risk is that those at the bottom might hang around their current price for years and never make a move to the upside.
The easiest way to calculate a P/E ratio is to use "trailing" earnings – the real earnings shown on the income statement. Some analysts like to make a growth forecast for the next year and then quote the stock on a "forward P/E" basis, often called the PEG ratio. For example, a stock with a current P/E of 50 that is expected to double EPS next year would trade at a forward P/E of only 25.
A forward P/E is always a better way to view the whole value idea, but naturally there are problems deciding exactly what the future earnings growth is likely to be. So I tend to rely on the trailing P/E to measure relative value, keeping in mind that a stock trading way above its historical multiple, or well above the industry P/E, had better be up there for a good reason (like dramatically improved productivity or a promising new product).
I also keep in mind that a stock with a low P/E might not be a great bargain if the company is having problems. But assuming the stock clears the other fundamental hurdles described above, a relatively low-P/E stock compared to its own history or industry average might just be the perfect value you've been looking for.
Hopefully this overview showed that you can get useful information from an income statement with very little effort. Many of these numbers and ratios can be found on most financial websites, but I have found it is useful to quickly scan through the numbers myself. Every company is different, but once you get used to looking at the numbers directly you will often be able to quickly spot anything that looks unusual. Knowing the full financial picture of a company can give you greater confidence when placing trades, or perhaps stop you from placing an ill-considered one