by Richard Loth (Contact Author | Biography)
To a large degree, it is the quality and growth of a company's earnings that drive its stock price. Therefore, it is imperative that investors understand the various indicators used to measure profitability. The income statement is the principal source of data to accomplish a profitability analysis, which should cover at least a five-year period in order to reveal trends and changes in a company's earnings profile. (To learn more basics on the income statement, see Understanding The Income Statement.)
With regard to the income statement, investors need to be aware of two things related to a company's accounting practices. First, the degree of conservatism, which indicates the degree of investment quality. The presentation of earnings depends, basically, on three accounting policies:
- revenue recognition,
- inventory valuation and
- the depreciation method.
While the so-called "bottom line" (net income) gets most of the attention from financial analysts and investors in any discussion of profit, the whole earnings process starts with a company's revenue, or net sales. The growth of this "top line" figure is a key component in producing the dollars needed to run a company profitably. A healthy sales growth rate generally defines a growing company and is a positive investment indicator.
- more unit volume from existing products/services,
- the introduction of new products/services,
- price increases,
- acquisitions and,
- for international sales, the impact of favorable exchange rates.
- greater unit volume is the best growth factor,
- followed by product-line expansion and
- new services.
In the income statement, the absolute numbers don't tell us very much. A simple vertical analysis (common size income statement) - dividing all the individual income and expense amounts by the sales amount - provides profit margin and expense percentages (ratios) for the whole income statement. Looked at over a period of five years, an investor will have a clear idea of the consistency and/or positive/negative trends in a company's management of its income and expenses. The success, or lack thereof, of this important managerial endeavor is what determines, to a large extent, a company's quality of earnings. A large growth in sales will do little for a company's profitability if costs grow out of proportion to revenues.
Also known as special, extraordinary or non-recurring, these items, generally charge-offs, are supposed to be one-time events. When they are, investors must take these unusual items, which can distort evaluations, into account, particularly when making inter-annual profit comparisons.
In addition to profit margin ratios, the return on equity (ROE) and return on capital employed (ROCE) ratios are widely used to measure a company's profitability. ROE measures the profits being generated on the shareholders' investment. Expressed as a percentage, the ROE ratio is calculated by dividing net income (income statement) by the average of shareholders' equity (balance sheet). As a rule of thumb, ROE ratios of 15% or more are considered favorable.
While an absolute increase in net income is a welcome sight, investors need to focus on what each share of their investments are producing. If increased net income comes as a result of profits from increased share capital, then earnings per share (EPS) is not going to look so great, and could fall below the previous year's level. An increase in a company's capital base dilutes the company's earnings among a greater number of shareholders. (To learn more, read Types Of EPSand How To Evaluate The Quality Of EPS.)
- convertible bonds,
- stock options and
- warrants were exercised.
- Logic tells us that growing, profitable companies are generally attractive investment opportunities.
- However, how that growth is achieved is more important than the absolute sales and income numbers.
- In addition, conservative accounting policies, substantive sales growth, consistent and/or improving profit margins, the absence of outsized write-offs, above average returns on equity and capital employed, and solid earnings per share performance are the hallmarks of top-level investment quality.
- It is this set of attributes that investors should attempt to find in the income statement before they invest.