By elmads

Have you ever wondered how do investors know if a stock is undervalued, fairly valued or overvalued? Then you will be hearing the words like value/valuations. It is as if those investing jargons are out of this world, but it isn’t.

Stocks are not just ticker symbols, they are part ownership of a company. Due to this, investors can peg the stock price of a corporation to its business performance and financial statements. This is also the reason why we investors could point out if a stocks is in under priced, fairly priced or overpriced through valuations.

Nevertheless, for investors to learn these valuations they should learn first how to understand the company’s financial statement. This includes the Income statement, Balance sheet and Cash flow statement. Yes, whether we like it or not, we need to learn this in order for us to grasp what the company really does, if it is trust worthy enough for our hard-earned money and if the risks it presents are manageable enough based on our risk tolerance.

It is not required for us to have degrees in finance and accounting to understand financial statements, but it is required of us to learn the very basics of it. Accounting is the language of finance, if we are not willing to learn about it, then we’ll never be able to understand it. It just literally like speaking to another person with a different language, we’ll never understand what they’re trying to communicate to us, not unless we know the language they are using.

Income statement shows the revenue of a firm and its expenses in a given time period. This is usually Yearly or Quarterly. In an individual level, we could compare it to our salary pay breakdown.

Without delay, I now present to you the fundamental parts of the income statement.

For this to be easier to explain, I will use Apple’s fiscal year 2020 Income statement as an example.

Before we start, we need to take note what currency does the statement show and the smallest denomination of its numbers. In our example above the currency is indicated as US Dollars while the least number of amount is stated in millions of USD. Also, we need to take note what time period it illustrates, in the example above it depicts the “Twelve Months Ended” meaning for the whole year of 2019 left hand column and 2020 at the right hand column.

NOTE: For it to be comprehensible, we will just focus on Apple’s 2020 income statement performance.

NET SALES

• Revenue – This is the total amount of money that the company made based on their business operations in a specific time period. Take note, this is always at the top of the financial statement because as we proceed down the statement, the deductions will be included up until we arrive in the company’s net income. In addition, revenue can be compared to our total gross pay of our salary.

Furthermore, in Apple’s income statement we could see that they generated 274 billion in revenue, take note that the least denomination is in millions. So, that’s 274 billion and 515 million = 274,515.00

• Cost of Revenue/Goods – This is the cost that is directly tied up to the production, marketing and distributing of products and services being sold. In apples case, this is the materials needed to make their products such as the iPhone, iPad, and Mac Book, and its shipping. What we have to remember is that anything that they spent to make and create their main products and services will be under the Cost of Revenue or Goods sold.

• Gross Profit – This is the what we get after subtracting the Revenue to the Cost of Revenue. In apple’s case it is 104 billion USD.

• Gross Margin (%) – If we try to divide the Gross Profit to its Net Revenue we will arrive to its gross margin. In apple’s case the Gross margin is 37.82% and 38.23% in 2019 and 2020, respectively. Gross margin shows the relationship of the Revenue and Cost of Revenue.

The the more stable or the more the Gross margin increases, the better, as it indicates either a strong revenue growth compared to the cost of revenue, or the cost to make their products are decreasing and with average revenue growth. The situation for a company is if their Revenues are increasing while the cost to make the products that translates into their revenues are also decreasing.

OPERATING EXPENSES

• Research and development – As the name states, it is an activity that companies do in order to improve their current products and services, and/or innovate new product and services. In this part of the statement, we will see the amount that the company placed in this segment. In the recent release of apple products in 2020, they presented their first and new made microchip called M1, which will be placed into their new Mac devices. It is designed by the company itself, through their extensive research and development method. This resulted to removing the need to purchase and rely on the microchips from Intel (the previous supplier of microchips for Apple). This in turn could lead to a decrease on the cost of revenue for Apple in the long run, henceforth a possible increase in gross margin and in their net income.

• Selling General and Administrative (SG&A) – It is the costs that are not directly correlated to making the products or services, but is tied to the day to day operation of the business. Namely, employee salary wages, rent, utilities, advertising, marketing, insurance, buildings and many more. We can compare this to our own basic needs expenses.

Operating Income (Gross Income – Operating Expenses)

• Operating Income / Earnings Before Interest and Tax (EBIT) – We get this number by subtracting the Gross Margin to the Total Operating Expenses (SG&A, R&D and other expenses needed to run the business). In the Apple example above, their EBIT is 66 Billion USD after subtracting their operating expenses for FY 2020.

• Operating Margin (%) – We get this by dividing the operating income/EBIT to its total revenue. The consistent and the higher the margin is, the better. This can indicate a lot of reasons, it can be the increase/decrease of SG&A, R&D or Depreciations/Amortization and many more. Metrics like this are best compared to the company’s previous Operating margins in order to see if there are any significant changes and if there is, we then need to look deeper into the annual reports to know what caused the changes.

Maybe an increase in their marketing and advertising expenses, which could by the way be a strategy of the company to entice more consumers to buy more apple products and subscriptions. Or, a significant increase in their Research and Development, which could be for a future plan that they are really keen to pursue, like a business expansion to autonomous driving. There are massive things we need to consider and read when analysing financial statements and annual reports.

• Other income/(expenses), net – This part of the statement are income or expenses that are not directly tied to the main operations of the company, such as selling buildings and equipment. The currency conversion gains/losses, interest gained from banks, penalty for customers, employees and suppliers. Generally, if it is the amount of money they gained or lost that are not directly related to their main business operations.

To give you context, let’s just say that you’re an employee whose main income comes from employment, but you also have a side hustle. Your side hustle income, in a sense, is the Other income/expenses of a company.

• Income before Tax / Earnings Before Tax (EBT) – computed by adding the Operating Income (EBIT) to Other income/expenses. Why not just add all income all together? why segregate it? Because we have to see which income and expenses is directly tied to the business, and which ones are not. Henceforth the sections, operating income/expenses and other income/expenses.

Also, it removes the noises of the other income/expenses away from the productivity, growth and profitability of the main business operation. There are instances where the net income will shoot up to the roof, not because the revenues went up, but because the company probably sold mass amount of their equipment, various factories or hectares of land, which will definitely influence the net income, but it is not actually related to the business operations.

• Interest Expense – Apple’s income statement does not show this section, but under this part is the debt obligation that they paid over a certain period in time. Included are the interest they owe on bonds, loans and lines of credit. This is important, because the more the company owes in debt the more they will pay for yearly interest.

To give you context, Interest expenses are like the interest payments of individuals who has credit card debts in their name. This is a debt obligation that they need to pay to the person or group of people they owe the money to.

• Income Tax – This is the tax that the company needs to pay, the tax rate will be different per country but with company giants like Apple who operates worldwide, the amount shown in their income statement will always be the net amount they paid for taxes, because the currency fluctuations are different for every country as well.

• Net income/profit (gain/loss) – This is also known as the bottom line because all of the deductions have been considered. This is where the exciting part comes in, it is to know where will the company utilize their net income. Will it be to pay debt, reinvest into the company through R&D, new equipment, to buy back stock shares of their company, to give it to their common shareholders via dividends, leave it as cash reserve or the mix of all of it.

• Net Income Margin (%) – We arrive to this percentage by dividing Net Income to its Total Revenue. With this measure, we will be able to see how profitable is the company after all deductions. The consistent and higher it is the better.

Margins are best used as a comparison to previous fiscal year margins of the company as it will give us a better view if the company has been improving, declining or being stagnant. Furthermore, margins are also utilized via comparative measures to different companies in the same sector or industry. For instance, we can compare the margins of Apple to, Samsung, Microsoft, Lenovo and Dell. The companies who have better margins in an industry could warrant us to do further research, because the question that will come into our minds is, why is this company have better margins than their competitors? what are they doing differently that gives them better margins compared to others.

With these information, we can now move forward to know the relationship of the stock market and the company, through shares outstanding and earnings per share.

• Shares Outstanding – It is the total shares of the company, these shares change when company buyback their shares or dilute the company into more shares to raise more capital. Also, the number of shares are determined and decided by the directors of the company. I have discussed these further into my blog titled “Stock and Shares”.

• Earnings Per Share (EPS) – We get this by dividing the Net Income of the company to the Total Shares Outstanding of the year. In Apple’s 2020 fiscal year the EPS is $3.28 . This is by dividing the 2020 Net income = 57,411 Billions USD to its diluted shares outstanding of 17,528.

NOTE: The difference of Basic and Diluted EPS, are based on the shares outstanding of the company. The basic is just the ordinary shares declared by the company, whereas the diluted includes all the complexities of convertible securities like employee stock options, convertible bonds, stock options and more. Diluted shares outstanding have higher number of shares compared to Basic shares outstanding. Investors usually use the Diluted Shares Outstanding and Diluted EPS to have a more conservative valuations into their analysis.

The Company and its Stock Price

• Price-to-Earnings Ratio (P/E Ratio) – This is what links the company’s net income to its stock price. This is the most popular valuation method to know if the company is over, fairly or under valued. This is computed by Dividing the Current Company Stock Price to its Earnings Per Share (EPS).

Apple’s Market Stock price as of 14/02/2021 = 135.37

Apple’s Diluted EPS as of Fiscal Year 2020 = 3.28

Apple’s P/E Ratio = 135.37 / 3.28

Apple’s Price-to-Earnings Ratio = 41.27

P/E Ratio in the most simplest interpretation is this. Investors are willing to pay $41.27 for $1 of the company’s current earnings, this is based on Apple’s PE Ratio. It is said that when PE Ratio is below 10 then it is undervalued, while 10-19.99 is fairly priced and 20-29.99 is overvalued, whereas 30 and above is extremely overvalued.

Nevertheless, this popular relative valuation method has a lot of flaws. It is just used as a quick basis only, but not as the main valuation to make a decision if we need to invest in a stock or not. Just like when doctors make their medical diagnosis, they do not just base it form one medical diagnostic, they still need to do series of tests like radiography, blood examinations, scans and more. This is for the purpose to arrive into the most accurate and detailed diagnosis possible, to mitigate the risk of wrong diagnosis and to treat the medical problem correctly.

There are a lot of valuation methods in the world of investing, which I will be sharing to you in my upcoming blogs.

To sum it up

The information I gave to you are the basic parts of an income statement, but as you continue to get exposed into reading income statements you will surely encounter different parts of it that are unfamiliar. This is because some companies have different methods of showing their financial statements and it is also dependent in the industry where the company is.

In particular, the banking industry, they have a different way of presenting their income statement as they are directly tied to interest rates and have a different business model compared to other industries. Once we understand how the income and expense component of the income statement is, we will then appreciate how the company makes money and be profitable. It is like decoding how companies become profitable and understand how they do it, which is the exciting part of fundamental analysis.

“The capacity to learn is a gift; the ability to learn is a skill; the willingness to learn is a choice.”

– Brian Herbert

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.