Dissecting Income Statement
Knowing income statement real well is critical to your investing
success. Income Statement is crucial in determining the fair
value of a common stock. Why? Because I believe that the fair
value of any investment is determined by the return it can
generate for a given price. If a common stock is trading at $
100 and it earns $ 4 annually, then it is yielding 4%. If a
treasury bond is yielding 5% right now, who would want to buy a
common stock which yields only 4%? To be honest, there are
probably some investors out there who will buy stocks at any
price. However, this type of investing is seldom profitable.
Analyzing income statement will tell us how much profits a
company can earn. This will in turn tell us how much percentage
return we can expect. So, without further ado, let us go through
the components of a typical income statement.
Revenue. Also called sales, Revenue is the lifeblood of
a company. To earn revenue, a company has to sell. For retail
companies like Walmart, you have to sell items at the stores.
For service companies such as H&R Block, it has to sell its
expertise to tax filers.
Cost of Revenue. Sometimes called Cost of Good Sold, Cost
Revenue is the direct cost of providing a particular good or
service to customers. For example, the cost of selling one can
of soda at Walmart is the price it bought the soda from
manufacturers.
Gross Profit This is the difference between the price of
good or service that a firm sells and the cost of providing that
particular good or service. In other words, it is the mark up
that a firm impose on its customers. For example, if Walmart
sells a can of soda for $ 1.00 while it costs $ 0.60 from the
manufacturer, then gross profit of Walmart for selling that can
of soda is $ 0.40. When gross profit is expressed in term of
percentage, it is called gross profit margin. In this case,
gross profit margin of Walmart is ($0.40/ $ 1.00) x 100% = 40%.
Research & Development.This is the cost of doing research
in order to provide future revenue or cost improvement. Either
way, it is designed to boost the firm's future profit. For
example, Walmart may spend certain dollars in order to improve
its inventory management, which in turn will reduce cost of
operating its business.
Selling General & Administrative. This is a really broad
category. Basically, this is the fixed cost of doing business.
Marketing expense, office rent, manager and the CEO's salary is
included here. So do depreciation and amortization expense. For
your information, depreciation expense is the expense incurred
every year for buying a long-term assets such as machinery or
vehicle. Amortization expense is the expense incurred for
obtaining goodwill, which is obtained from acquiring companies
above its net asset value. When a company is considering
layoffs, it is this cost that they are trying to reduce.
Operating Income. This is the difference between gross
profit and operating expenses. Operating expense here is the
total cost of research development and selling general &
administrative. Operating income can be thought as the income
generated as a result of a firm's primary business activities.
Other Income/Expense. This is the income earned or
expense incurred outside of the firm's business activities. For
example, capital gain on sale of asset or expense incurred due
to lawsuit punitive damage.
Interest Expense. This is the expense incurred from
borrowing long term debt. A firm gets additional funding by
borrowing money. In turn, it has to pay interest for the loan.
This interest is called interest expense.
Income Before Tax, Income Tax Expense. Once you take out
all the other income/expense and interest expense from operating
income, you get income before tax. A profitable firm has to pay
tax on this income. The tax paid by the firm is found in the
income statement under category income tax expense.
Net Income. This is our final destination. This is the
reason why we go through all the components of an income
statement. Also known as net profit, net income is what a
company earns at a specific time frame. From here on, you can
then calculate the fair value of the firm. Does it yield less
than 4% treasury bond, which is considered safe haven? If so,
the common stock definitely needs to be sold or avoided.
Please note that each companies have different ways of
presenting their income statements. However, most companies
present them similar to the above criteria. If some companies
give a totally different ways of presenting their financial
performance, it is best to ask them questions or avoid the
common stock altogether.