The first document you should look at in analyzing a stock is the Income Statement. An income statement is an overview of how much a company has earned in a specific period of time. The time frame is most often either on a quarterly or annual basis. A business may choose the fiscal year that works best for the business needs; it does not have to correspond to the calendar year of January through December. The top line across the income statement is the number of years being analyzed; you need to see data dating back at least five years to make an informed decision about a stock.
Recommended Reading
Peter Lynch, “Beating the Street”, (1994).
The next line is Revenue and Gross Profit. This is all the money coming into the business, without regard to any deductions, in payment for its goods and/or services. (The issue of revenue recognition is an extensive topic. For our purposes, an easy method of analysis is for revenue recognition to be based on when the control of the product is transferred to the buyer.)
What you want to see is Revenue and Gross Profit steadily going up. If you see a company’s revenues go from seven billion to thirty one billion in five years, you know that the market is responsive to a product that the company is selling. If you see rising revenue and gross profit, dating back five years, this company would be worth further analysis.
The next category to consider is the Cost of Revenue because it takes money to make money. Where money is recognized in a specific time frame, the cost to produce such revenue must also be recognized in that same period, according to the accounting principle of matching. As sales increase, the cost of revenue usually increases as well.
Every type of revenue source, whether a product or a service, has different costs associated in acquisition. For example, products must be physically delivered. Services require payroll. As such, cost of revenue is variable. A subcategory of cost of revenue is gross margin; revenue minus the cost to produce the revenue is gross margin. On the income statement, gross margin is expressed as a dollar figure and may be looked as a percentage. If a company has income of $100.00 and it cost $66.00 to produce the revenue, the gross margin is $66.00 and 66% of revenue. The net income is thus $33.00. Revenue is at the top of the income statement and Net Income is at the bottom of the income statement. This is known as the top line and the bottom line of the income statement.
The next area of analysis on the Income Statement is Operating Expenses. These costs are not directly related to the number of units sold or services provided and thus are not considered costs of revenue; these costs are under the discretion of management. Things like administrative expenses, labor costs, advertising, research and development are listed here. Restructuring costs can only be listed if an actual restructuring is taking place. The subtraction of this category of expense establishes the amount of Operating Income. This is revenue minus cost of revenue, minus operating expenses.
The next category of analysis is Other Income (also called Non-Operating Income and Expenses). Interest income and expense, and net recognized gains on investments are identified here. This is called other income because it is not originated by the core functions of the business. This income has to be recognized somewhere and so it is placed in other income. The next category on the Income Statement is taxes. This is not necessarily how much income tax was paid. Rather, it is an estimate of the income tax expense. The amount for provision in income taxes can fluctuate from year to year.
This finally brings us to Net Income, the bottom line of the Income Statement. Net income is revenue, minus cost of revenue, minus operating expenses, plus or minus other income, minus provision for income taxes.
As such, these are the main figures on the income statement that you should be looking at in analyzing a stock: revenue, gross margin, operating income, and net income. These figures give you the most meaningful information about what is going on with the income of a business.
Recommended Reading
Peter Lynch, “Beating the Street”, (1994).
