If you are investing in stocks, you know the importance of evaluating a company. Income evaluation is undoubtedly the first step to take when evaluating a company.
How do companies work?
In order to understand a company’s income statement, let’s first think, what even is a company? How does a company do? How does it work?
Legally, a company is simply a legal structure where one or more people get together to perform some tasks, generally a business. The company provides a shell to ringfence the business, so that there is a clear separation of concerns between its individual owners, and the business itself. A company, then can be thought of as a container of a business – though that business may itself be the acquisition of other companies and/or business. For example, Berkshire Hathaway, is a holding company, whose main business is to buy other businesses, such as See’s Candies, etc. Another interesting example of a “container” company is the SPDR S&P 500 Trust ETF. It is an investment company structured as an exchange traded fund (ETF), with the ticker symbol SPY, and its main business is to buy and hold stocks to track the S&P500 index.
Regardless of the business a company is in, there are a few common aspects shared by all of them:
- Companies typically seek commercial profit (excluding charities and nonprofits companies).
- Companies generally have one or more products. Products may be tangible, like a watch, a car, etc., or they may be intangible, like a website, an onlineservice, etc.
- Companies start by taking money from investors (also called shareholders) to invest in producing the products. (note that this refers only to the initial investors, generally before the company starts trading on the markets. If you buy shares of a company with a broker, the company does not generally see a single cent of that money – instead, that money goes to pay off earlier investors, who sold you their shares.)
- They may also sell bonds or otherwise acquire debt to raise cash to invest in producing the products.
- Finally, they sell the products, ideally at a price higher than the cost of manufacturing the products. If they manage to do so, they make a profit.
- Profits can then be retained by the company to invest in producing future products, or they can be used to pay down debt, or returned to investors via dividends, or to reduce the number of investors / outstanding shares by buying back shares.
Keywords in income statement
Income statements can be very long. But there are only a handful of keywords or key phrases an investor should understand in order to evaluate a company.
- Revenue (or Gross sales): The total amount of money the company generates from the sales of its products. This is usually the first line of a company’s income statement.
- Operating expenses: The expenses that the company incurs through its day to day business operations, including costs of customer acquisitions, payroll for its workers, research and developments, etc. This is also referred to as “fixed costs”.
- Cost of goods sold (or Marginal costs): The expenses that the company incurs directly in the production of its products. For example, the costs of the materials used to produce the products, the payroll for factory workers, etc.
- Gross income (or Gross margin or Gross profit): Revenue – cost of goods sold.
- Operating income (or Operating profit): Gross income – operating expenses.
- Non-operating income: Any income that the company receives that is not due to its primary business.
- Non-operating expenses: any expenses that the company incurs that are not due to its primary business.
- Income before tax: This is the total amount of profit the company makes before paying its taxes.
- Net income: This is the income of the company, after paying (or setting aside money for) any taxes it may own.
There are several other metrics in the statement, including normalized income after/before tax, weighted average shares outstanding, etc., but they are not essential to the evaluation of a company’s performance, so I’ll skip them here.
With the income statement metrics at hand, we can compute some evaluation metrics.
- Price / Earning (P/E) ratio: The most popular ratio, P/E ratio is available on almost every major financial research platform and provides a quick and easy reference number that is reasonably comparable across multiple industries. The intuitive interpretation of this ratio is “how much do I pay, for $1 of net income?”
- Price / Sales (P/S) ratio: Similar to P/E ratio, P/S ratio essentially answers the question, “how much am I paying for each dollar of sales?”
- Price / Earnings-to-Growth (PEG) ratio: To account for potential future growth, the P/E ratio is sometimes augmented by normalizing it against projected (or historical) earnings growth, which is called PEG ratio.
How much do we want to pay?
With the evaluation metrics, especially the P/E ratio, we can answer, if we buy the share of a company, how much we are actually paying for each dollar the company makes. This raises another question, how much do we want to pay?
Unfortunately, there is really no simple answer to this question. However, when looked across industries, the P/E ratio can serve as a pretty good yardstick to evaluate different companies. Say Company A has a P/E ratio of 100 (we pay $100 for $1), and Company B has 20 (we pay $20 for $1), and everything else about the 2 companies are the same, I’d put my money on Company B simply because Company B is undervalued in terms of P/E ratio.
With that said, income statements serve as an essential part when conducting evaluation of a company. And I do believe every investor should master this skill in order to be more successful.