Reading an income statement: Revenues and Costs

The income statement gives a more detailed answer to a critical question for any investor: is the company making money? A well-known expression the bottom line comes from income statements. Specifically, it refers to a company's net income. While this is obviously an important figure, it's worth reviewing an income statement line-by-line. There may be little bits of good news or red flags revealed along the way to calculating that final figure.

The income statement starts with net sales or revenues, the top line. When analysts refer to top-line growth, what they really mean is: Are total revenues growing or shrinking? This is important because if the top line isn't growing, where will sustainable growth come from?

The next two lines cover what it cost the company to produce the products and services sold. Cost of Goods Sold (COG) covers direct costs of materials, labor, et cetera. Just lump depreciation, depletion and amortization together as an indirect cost associated with production.

Another line item of cost is selling, general and administration expenses (SG&A). These costs pertain to operating the company and promoting the product. Watch SG&A closely. Problems often show up here before they are apparent in the bottom line.

Reading an income statement: Margins and Earnings

Gross income is calculated by subtracting costs from revenues. Gross income plays an important role in calculating gross margin. This ratio measures what percentage of revenue is profit after you remove the costs associated with producing it.

For example, if Drive Rite Motors had $100 million in gross revenues and $70 million in costs, gross margin would be 70/100=0.7. In other words, the company's cost to produce $100 million in revenue is 70% of that revenue. Gross margin refers to the percentage of that amount that's profit, the remaining 30%.

Is a 30% gross margin good? You'll need to compare this company's gross margin with its competitors to benchmark this particular industry. It's also smart to consider whether a company's gross margins are going up or down over time.

Operating income is calculated by subtracting SG&A from gross income. Pay close attention to operating margin, which is operating income as a percentage of revenue. And keep an eye on profit margin, which is net income expressed as a percentage of total revenue.

Reading an income statement: Earning Ratios

You'll hear investors discussing three earnings-based ratios a lot: EPS, P/E and PEG.

Earnings Per Share (EPS) — this refers to the total amount a company earned in a given timeframe, divided by the number of outstanding shares. EPS is one of the most-quoted indications of a company's current health.

Price-to-Earnings Ratio (P/E). Since you're buying a share of the company to get a share of their earnings, you should want to know how much you're paying for that privilege. P/E can be a handy yardstick for whether you're paying dearly to tap a company's earnings stream, or whether you're getting a bargain.

P/E is calculated as follows: you take the price of the stock and divide it by the EPS. P/E is always quoted using annual earnings.

How do you determine P/E? Again, numbers like these are relative to the company's sector and current market conditions. You should compare your company's P/E to that of its chief competitors, and then check out the average P/E for the S&P 500.

Price/Earnings-to-Growth (PEG). When you start comparing the P/E ratios of various stocks, you may find it confusing. XYZ has a P/E of 59; ABC has a P/E of 12. Does that mean XYZ stock is over-priced and ABC's is a bargain? Maybe. Why doesn't the market establish what the P/E ratio should be and adjust all stock prices accordingly?

The short answer is that earnings change, and individual stock prices are determined by the expectation of future earnings. By contrast, P/E and EPS give you only a snapshot in the past. Another problem is in the way companies report earnings and the way in which the market interprets them. If a company has a “one-time charge against earnings” for some extraordinary reason, this lowers EPS. However, the market may focus more on what earnings would have been if the one-time charge were ignored.

How should you compare these numbers? Enter PEG, an earnings ratio that tries to account for future growth. It's calculated by taking the P/E ratio and dividing it by the annual EPS growth rate. PEG is a widely used measure of valuation. A PEG of one suggests the stock is fairly valued. If it's greater than one, the stock may be over-priced. If less than one, the stock may be undervalued. PEG is useful in evaluating high-growth stocks, because even though their current earnings may be modest, the expectation is that these companies are poised for potentially explosive growth.

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