Lesson 4 MaterialAnalyzing an Income Statement

Introduction

The primary objective of the income statement is to report to investors how much money a business made or lost during a specific period of time. Years ago, it was referred to as the Profit and Loss (or P&L) statement, and has since evolved into the most well-known and widely used financial report on Wall Street. Many times, investors make decisions based entirely on the P&L report without consulting the balance sheet or cash flow statements (which, while a mistake, is a testament to how influential it is).

To an enterprising investor, the income statement reveals much more than a business’ earnings. It can give important insights into how effectively management is controlling costs, how much is being spent on research and development, the total amount of taxes paid, and interest coverage. In a few short minutes, an investor or analyst can also calculate profit and operating margins to compare a company to its competitors.

As we progress through this series of investing lessons, you must remember John Burr William’s basic truth that a business is only worth the profit that it will generate for its owners from now until doomsday, discounted back to the present, adjusted for inflation. The income statement is the “report card” of those earnings, which ultimately determine the price you should be willing to pay for a business.

Sit back in your chair, take out a copy of an annual report, and let’s begin working through it. In the end, I think you’ll be surprised by how much you’ve learned. As always, there will be quiz following the lesson; you should be able to pass without missing more than two questions.

Below is a sample income statement taken from Walt Disney’s 2001 annual report.

It’s important to note that not all income statements look alike, although they necessarily contain much of the same information. As we work our way through various income statements, you will inevitably find they are much simpler and comparable than may appear at first glance.

Total Revenue or Total SalesThe first line on any income statement is an entry called total revenue or total sales. This figure is the amount of money a business brought in during the time period covered by the income statement. It has nothing to do with profit. If you owned a pizza parlor and sold 10 pizzas for $10 each, you would record $100 of revenue regardless of your profit or loss.

The revenue figure is important because a business must bring in money to turn a profit. If a company has

less revenue, all else being equal, it’s going to make less money. For startup companies and new ventures that have yet to turn a profit, revenue can sometimes serve as a gauge of potential profitability in the future.

Many companies break revenue or sales up into categories to clarify how much was generated by each division. Clearly defined and separate revenues sources can make analyzing an income statement much easier. It allows more accurate predictions on future growth. Starbucks’ 2001 income statement is an excellent example: 

Starbucks CoffeeConsolidated Statement of Earnings – Excerpt

Page 29, 2001 Annual Report

In thousands except earnings per share

Fiscal year ended Sep 30, 2001 Oct 1, 2000

Net Revenues    

   Retail $2,229,594 $1,823,607

   Specialty 419,386 354,007

Total net revenues 2,648,980 2,177,614

Starbucks’ sales come primarily from two sources: retail and specialty. In the annual report, management explains the difference between the two several pages before the income statement. “Retail” revenues refer to sales made at company-owned Starbucks stores across the world. Every time you walk in and order your favorite latte, you are adding $3-5 in revenue to the company’s books. “Specialty” operations, on the other hand, are money the company brings in by sales to “wholesale accounts and licensees, royalty and license fee income and sales through its direct-to-consumer business”. In other words, the specialty division includes money the business receives from coffee sales made directly to customers through its website or catalog, along with licensing fees generated by companies such as Barnes and Nobles, which pay for the right to operate Starbucks locations in their bookstores.

Cost of Revenue, Cost of Sales, Cost of Goods Sold (COGS)Cost of goods sold (COGS for short) is the expense a company incurred in order to manufacture, create, or sell a product.  It includes the purchase price of the raw material as well as the expenses of turning it into a product.  Cost of goods sold is also known as cost of revenue or cost of sales.

Going back to our Pizza Parlor example, your cost of goods sold include the amount of money you spent purchasing items such as flour and tomato sauce.

Gross ProfitThe gross profit is the total revenue subtracted by the cost of generating that revenue. It tells you how much money the business would have made if it didn’t pay any other expenses such as salary, income taxes, etc.  Gross Profit should be broken out and clearly labeled on the income statement. Here’s the formula to calculate it yourself:

Total Revenue - Cost of Goods Sold (COGS) = Gross Profit

The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss in a moment.

Gross Profit MarginAlthough we are only a few lines into the income statement, we can already calculate our first ratio. The gross profit margin is a measurement of a company’s manufacturing and distribution efficiency. A company that boasts a higher percentage than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors.

To calculate gross margin, use this formula:

Gross Profit----------(divided by)----------

Total Revenue

For illustration purposes, let’s calculate the gross margin of Greenwich Golf Supply (a fictional company). 

Greenwich Golf SupplyConsolidated Statement of Earnings – Excerpt

In thousands except earnings per share

Fiscal year ended Sep 30, 2001 Oct 1, 2000

Total Revenue $405,209 $315,000

Cost of Sales $243,125 $189,000

Gross Profit $162,084 $126,000

Assume the average golf supply company has a gross margin of 30%. [You can find this sort of industry-wide information in various financial publications, online finance sites such as moneycentral.com, or rating agencies such as Standard and Poors].

We can take the numbers from Greenwich Golf Supply’s income statement and plug them into our formula:

$162,084 gross profit----------(divided by)----------

$405,209 total revenue

The answer, .40 [or 40%], tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned. For more information on warning signs of accounting fraud, I recommend Howard Schilit’s Financial Shenanigans: 2nd edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports

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Putting It Together Thus Far:We’ve actually covered a lot of ground. Here’s an example to help reiterate and / or clarify everything we’ve discussed.If the owner of an ice cream parlor purchased 10 gallons of vanilla ice cream for $2 per gallon, and sold each of those gallons to her customers for $5, the first three lines on her income statement would look something like this:

Total Revenue $50(The total revenue is the amount of money rung up at the cash register. The owner sold 10 gallons of vanilla ice cream    to her customers for $5 per gallon. 10 gallons x $5 a gallon = $50.)

Cost of Revenue $20(The cost of goods sold was 10 gallons x $2 per gallon = $20)

Gross Profit $30(The total revenue subtracted by the cost to earn that revenue is $30. Before taxes, and other expenses, this is the ice cream parlor’s gross profit.)

Gross Margin: .6 (or 60%)

Operating ExpensesThe next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business.  Operating expenses consist of salaries paid to employees, research and development costs, and other misc. charges that must be subtracted from the company’s income.  As an investor / owner, you want to work with managements that strive to keep operating expenses as low as possible while not damaging the underlying business.

Research and DevelopmentR&D costs can range from nothing to billions of dollars, depending upon the type of business you are analyzing. Unlike many other costs (such as income taxes), management is almost entirely free to decide how should be spent. In 2001, Eli Lilly, one of the world’s largest pharmaceutical companies, plowed nearly 26% of the total gross profit back into R&D.

How much should a company spend on R&D? It depends. In highly creative and fast-moving industries, the amount of money spent on the research and development budget can literally determine the future of the business. If Eli Lilly stopped funding the development of new drugs, its future profitability would suffer, causing a perhaps permanent decline in earnings. In such cases, it may be appropriate to compare the

level of R&D funding to profitability over time, as well as to the percentage of gross profit competitors spend on research and development.

Selling General and Administrative Expenses (SG&A)SG&A expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. High SG&A expenses can be a serious problem for almost any business. A good management will often attempt to keep SG&A expenses limited to a certain percentage of revenue. This can be accomplished through cost-cutting initiatives and employee lay-offs.

There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit. In the 1980’s, ABC (later merged with CAP Cities, then bought by Disney) was spending $60,000 a year on florists, as well as providing stretch limos and private dining rooms for its executives. It was the shareholders who were footing the bill. [On a related note: at the same time these ABC executives were squandering shareholders’ capital, they were artificially padding earnings by selling original Jackson Pollack and Willem de Kooning paintings the network owned!]

Goodwill and other Intangible Asset Amortization ChargesIn the past, companies were required to charge a portion of goodwill to the income statement, reducing reported earnings. For all good purposes, these charges were ignored by the investor. In June 2001, the Financial Accounting Standards Board (FASB) [the folks who make accounting rules in the United States], changed the guidelines, no longer requiring companies to take these amortization charges. If the company, through cash-flow analysis and other means, determines that the goodwill is impaired [meaning it’s not worth the value it’s carried at on the balance sheet], management will announce a write-down and reducing the carrying value of the goodwill. Intangible assets that do not have indefinite lives [such as patents] will continue to be amortized.

The complexities of goodwill were explained in detail in the Goodwill section of Lesson 3: Part 23.

Non-Recurring and Extraordinary Items or EventsIn the unpredictable world of business, events will arise that are not expected and most likely not occur again. These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. This allows investors to more accurately predict future earnings. If, for instance, you were considering purchasing a gas station, you would base your valuation on the earning power of the business, ignoring one-time costs such as replacing the station’s windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for $17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future.

What is the difference between non-recurring and extraordinary events? A nonrecurring charge is a one-time charge that the company doesn’t expect to encounter again. An extraordinary item is an event that materially* affected a company’s finance and needs to be thoroughly explained in the annual report or SEC filings. Extraordinary events can include costs associated with a merger, or the expense of implementing a new production system [as McDonald’s did in the late 1990’s with the Made for You food preparation system].

Non-recurring items are recorded under operating expenses, while extraordinary items are listed after the net line, after-tax.

*The term material is not specific. It generally refers to anything that affects a company in a meaningful and significant way. Some investors try to put a number on the figure, saying an event is material if it causes a change of 5% or more in the company’s finances.

Accounting for Extraordinary and Non-Recurring Items or Events in Your AnalysisWhen calculating a company’s earning-power, it is best to leave one-time events out of the equation.

These events are not expected to repeat in the future, and doing so will give you a better idea of the earning power of the company.

If you are attempting to measure how profitable a business has been over a longer period, say five or ten years, you should average in the one-time events to paint a more accurate picture.  For example, if a company purchased a building for $1 in 1990, and sold it for $10 ten years later in 2000, it is improper to consider the company earned $10 extra in the year 2000. Instead, the extraordinary income [in this case, $10], should be divided by the number of years it accrued [10 years – 1990 to 2000]. $10 extraordinary income divided by 10 years = $1 a year.

Although the income statement will reflect a $10 one-time profit for the business, the investor should restate the earnings during their analysis by going back and adding $1 to each of the years between 1990 and 2000. This will increase the accuracy of a trend line. Since the asset was quietly appreciating during this time, it should be reflected.

Operating IncomeOperating income, or operating profit, is a measurement of the money a company generated from its own operations [it doesn’t include income from investments in other businesses, for instance]. Operating income can be used to gauge the general health of the core business or businesses.

Operating Income = gross profit – operating expenses

The operating income figure is tremendously important because it is required to calculate the interest coverage ratio and the operating margin

Operating Margin [or Operating Profit Margin]The operating margin is another measurement of management’s efficiency. It compares the quality of a company’s operations to its competitors. A business that has a higher operating margin than its industry’s average tends to have lower fixed costs and a better gross margin, which gives management more flexibility in determining prices. This pricing flexibility provides an added measure of safety during tough economic times.

To calculate the operating margin, divide operating income by the total revenue.

Operating income----------(divided by)----------

Total revenue

Interest IncomeCompanies sometimes keep their cash hoards in short-term deposit investments [such as certificates or deposit with maturities up to twelve months, savings account, and money market funds]. The cash placed in these accounts earn interest for the business, which is recorded on the income statement as interest income.

Interest income will fluctuate each year with the amount of cash a company keeps on hand.

Interest ExpenseCompanies often borrow money in order to build plants or offices, buy other businesses, purchase inventory, or fund day-to-day operations. The borrowed money is converted to an asset on the balance sheet (i.e., if a business borrows $1 million to build a distribution center, the distribution center would add $1 million of assets to the balance sheet after the cash was spent.) The interest a company pays to bondholders, banks, and private lenders, on the other hand, is an expense that it receives no asset for. Hence, interest expense must be accounted for on the income statement.

Some income statements report interest income and interest expense separately, while others report interest expense as “net”. Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. [In other words, if a company paid $20 in interest on its bank loans, and earned $5 in interest from its savings account, the income statement would only show interest expense – net $15.]

The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.

Interest Coverage RatioThe interest coverage ratio is a measurement of the number of times a company could make its interest payments with its earnings before interest and taxes; the lower the ratio, the higher the company’s debt burden.

Interest coverage is the equivalent of a person taking the combined interest expense from their mortgage, credit cards, auto and education loans, and calculating the number of times they can pay it with their annual pre-tax income. For bond holders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company’s earnings can fall before it will start defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business.

To calculate the interest coverage ratio, divide EBIT (earnings before interest and taxes) by the total interest expense.

EBIT (earnings before interest and taxes)-----------------------(divided by)-----------------------

Interest Expense

As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. A ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.

EBIT has its short fallings; companies do pay taxes, therefore it is misleading to act as if they didn’t. A wise and conservative investor would simply take the company’s earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety.

Depreciation and AmortizationThere are two different kinds of “depreciation” an investor must grapple with when analyzing financial statements, accumulated depreciation and depreciation expense. They are entirely different things, and are often confused with one another. In order to understand them, we must discuss them individually.Depreciation Expense

According to Ameritrade, “Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. [emphasis added] Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”

To help you understand the concept, let’s look at an example:

Sherry’s Cotton Candy Co., earns $10,000 profit a year. In the middle of 2002, the business purchases a $7,500 cotton candy machine that is expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 [$10k profit - $7.5k expense for purchasing the new machinery]. The investor would wonder why the profits had fallen so much during the year.

Thankfully, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five [$7,500 / 5 years = $1,500 per year]. Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is “depreciation expense”.

This presents an interesting dilemma; although the company reported earnings of $8500 in the first year, it was still forced to write a $7,500 check [effectively leaving it with $2500 in the bank at the end of the year [$10,000 profit - $7,500 cost of machine = $2,500 left over]. This means that the cash flow of the company is actually different from what it is reporting in earnings. The cash-flow is very important to investors because they need to be ensured that the company can pay its bills on time. The first year, Sherry’s would report earnings of $8,500, but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500, but have $10,000 in the bank since, in reality, the business paid for the machinery up-front in a lump-sum. Hence, if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.*

This is where the third major financial report, the Cash Flow Statement, is important. The cash flow statement is like a company’s checking account. It shows how much cash was spent, at what time, and where. That way, an investor could look at the income statement of Sherry’s Cotton Candy Co. and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing Lesson 5.

Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect. Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation will be apt to overvalue a business and find his or her returns lacking.

*Depreciation expenses are deductible; Sherry’s would only pay taxes on $8,500 each year, spreading out her tax burden to the future. Some investors assume incorrectly that the business would pay taxes on $2,500 the first year and the full $10,000 each year after.

Accumulated DepreciationIf you purchased a new car for $50,000 and resold it three years later for $30,000, you would have experienced $20,000 loss on the value of your asset. This $20,000 is due to a force called depreciation. Accumulated depreciation is the reduction of the carrying amount of the assets on the balance sheet to reflect the loss of value due to wear, tear, and usage. Companies purchase assets such as computers, copy machines, buildings, and furniture, all of which lose value each day. This depreciation loss must be accounted for in the company’s financial statements in order to give shareholders the most accurate portrayal of the economic realty of the business.

When you look at a balance sheet, if you see the entry “Property, Plant, and Equipment – net” it is referring to the fact that the company has deducted accumulated depreciation from the figure presented. To see the amount of those depreciation charges, you will probably have to delve into the annual report or 10k.

Straight Line Depreciation MethodThe simplest and most commonly used, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset subtracted by the salvage value divided by the total productive years the asset can be reasonably expected to benefit the company [called “useful life” in accounting jargon].

purchase price of asset – approximate salvage value-------------------------- (divided by) --------------------------

estimated useful life of asset

Example: You buy a new computer for your business costing approximately $5,000. You expect a salvage value of $200 selling parts when you dispose of it. Accounting rules allow a maximum useful life of five years for computers; in the past, your business has upgraded its hardware every three years, so you think this is a more realistic estimate of useful life, since you are apt to dispose of the computer at that time. Using that information, you would plug it into the formula:

$5,000 purchase price - $200 approximate salvage value-------------------------- (divided by) --------------------------

3 years estimated useful life

The answer, $1,600, is the depreciation charges your business would take annually if you were using the straight line method.

Accelerated Depreciation MethodsAnother way of accounting for depreciation is to use one of the accelerated methods. These include the Sum of the Year’s Digits and the Declining Balance [either 150 or 200%] methods. These accelerated methods are more conservative and, in most cases, accurate. They assume that an asset loses a majority of its value in the first several years of use.

Sum of the Years DigitsTo calculate depreciation charges using the sum of the year’s digits method, take the expected life of an asset (in years) count back to one and add the figures together. Example:

10 years useful life = 10 + 9 + 8 + 7 + 6 +5 + 4 + 3 + 2 + 1 Sum of the years = 55

In the first year, the asset would be depreciated 10/55 in value [the fraction 10/55 is equal to 18.18%] the first year, 9/55 [16.36%] the second year, 8/55 [14.54%] the third year, and so on. Going back to our example from the straight-line discussion: a $5,000 computer with a $200 salvage value and 3 years useful life would be calculated as follows:

3 years useful life = 3 + 2 + 1 Sum of the years = 6

Taking $5,000 - $200 we have a depreciable base of $4,800. In the first year, the computer would be depreciated by 3/6ths [50%], the second year, by 2/6 [33.33%] and the third and final year by the remaining 1/6 [16.67%]. This would have translated into depreciation charges of $2,400 the first year, $1,599.84 the second year, and $800.16 the third year. The straight-line example would have simply charged $1,600 each year, distributed evenly over the three years useful life.

Double Declining Balance DepreciationThe double declining balance depreciation method is like the straight-line method on steroids. To use it, accountants first calculate depreciation as if they were using the straight line method. They then figure out the total percentage of the asset that is depreciated the first year and double it. Each subsequent year, that same percentage is multiplied by the remaining balance to be depreciated. At some point, the value

will be lower than the straight-line charge, at which point, the double declining method will be scrapped and straight line used for the remainder of the asset’s life [got all that?]. An illustration may help.

In our straight-line example, we calculated that a $5,000 computer with a $200 salvage value and an estimated useful life of three years would be depreciated by $1,600 annually. The first year, we have to compare this to the total amount to be depreciated, in this case, $4,800 [$5,000 base - $200 salvage value = $4,800]. Dividing $1,600 by $4,800, we discover the straight-line depreciation charge [$1,600] is 33.33% of the total depreciation amount [$4,800]. Using this information, we double the 33.33% figure to 66.67%.

In the first year, we would take $4,800 multiplied by .6667 to get a total depreciation charge of approximately $3,200. In the second year, we would take the same percentage [66.67%] and multiply it by the remaining amount to be depreciated. Continuing with the example, we find that $1,600 is the remaining amount to be depreciated at the start of the second year [$4,800 - $3,200 = $1,600]. Multiply 1,600 by .6667 to get $1,066. This is the depreciation charge for the second year – or not! Remember that once the depreciation charges dip below the amount that would be charged using the straight-line method, the double declining balance is scrapped and straight line immediately utilized. The straight line method called for charges of $1,600 per year. Obviously, the $1,066 charge is smaller than the $1,600 that would have occurred under straight line. Thus, the deprecation charge for the second year would be $1,600.

For those of you who love algebra, you may find it easier to use this equation:

depreciable base * (2 * 100% / useful life in years)

Comparing Depreciation MethodsJust to reinforce what we’ve learnt thus far, here’s a look at what the depreciation charges for the same $5,000 computer would look like depending upon the method used. 

Comparing Depreciation Methods

Method Year 1 Year 2 Year 3

Straight Line

$1,600

$1,600 $1,600

Sum of the Years $2,400 $1599.84 $800.16

Double Declining Balance

$3,200

$1,600 $0

Obviously, depending upon which method is used by management, the bottom-line of a company can be seriously affected. The level of attention an investor must give depreciation depends upon the asset intensity of the business he or she is studying. The more asset-intensive an enterprise, the more attention depreciation should be given.

If you have two asset intensive businesses, and they are using different depreciation methods, and / or useful lives, you must adjust them so they are on a comparable basis in order to get an accurate picture of how they stack up against each other in terms of profit.

Some managements will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through SG&A expenses [for the deprecation costs of desks, for instance]. Either way, you should be able to garner the information either through the income statement itself or going through the annual report or 10k.

In Security Analysis [the classic 1934 edition], Benjamin Graham recommended the investor answer three questions when dealing with the effects of deprecation on a business [paraphrased]:

1. Is depreciation reflected in the earnings statement?2. Is management using conservative and [as much as possible] accurate depreciation rates? Accounting rules allow assets to be written off over a considerable time period. Buildings, for example, can be depreciated anywhere from ten to thirty years, resulting in large differences in charges depending upon the time frame a particular business uses. A company’s 10k filing should contain information on the rates employed by the company.3. Are the cost or base to which the depreciation rates applied reasonable accurate? A company may set unrealistic salvage values on its assets, thus reducing the amount of depreciation charges it must take every year.

Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA EBITDA tells an investor how much money a company would have made if it didn’t have to pay interest on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company’s financial performance, not free cash flow as many investor incorrectly assume, originally coming into existence in the 1980’s during the leveraged-buyout frenzy that epitomized the era of greed. The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.

In its brilliance, Wall Street regrettably forgot one part of the equation: common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these expenses like they don’t exist is the same mentality of the five year old who believes no one can see them when their eyes are closed – while they may enjoy pretending for a while, the IRS and the banks and bondholders who lent money to the company aren’t interested in playing games. When the bills come due, these entities want the money owed to them and can force bankruptcy if they aren’t paid.

Still not convinced? Picture this scenario:

A man making $100,000 annually walks into his local bank to get a loan on a new BMW. He pays an annual taxes of about $30,000, leaving his take-home pay at $1346.15 per week [for simplicity sake, let’s ignore payroll deductions, etc.] He currently has a mortgage payment of $750 a month, and student loan payments of $250 a month. After paying out this $1,000 each month, he is left with $346.15 to live on

The loan officer crunches the numbers and comes up with an estimated monthly payment of $400 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. “Sir,” she says, “you only make $346.15 a month after payments and taxes! You can’t afford this loan. Not only can you not afford the payment, you will then have nothing to live on.” The man looks confused, “but I make $1,346.15 per month before my payments and taxes.”

See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely aren’t. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.

The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can’t make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn’t be attained, they created a new one that made them appear successful.

In the accounting and business world, EBITDA is a firestorm of controversy. There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn’t worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don’t worry about it – four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it’s folly such as this that presents us with opportunity to profit in the market.

If you are interested, there is an excellent article at the Motley Fool’s website called The Limits of EBITDA. I highly recommend it.

Additional information:10 Critical Failing of EBITDA - Computer WorldEBITDA: The Good, the Bad, and The Ugly – InvestopediaIgnore EBITDA - The Motley FoolWhat is EBITDA - The Motley Fool

Income before TaxAfter deducting interest payments and [depending on the business] other expenses, the analyst / investor is left with the profit a company made before paying its income tax bill. It allows you to see what the business would have earned if it did not have to pay taxes to the government.

Income Tax ExpenseThe income tax expense is the total amount the company paid in taxes. This figure is frequently broken out by source [federal, state, etc.] either on the income statement or somewhere in the annual report or 10k.

You should be fairly familiar with the tax laws affecting specific companies and / or business transactions. For instance, say the business you were analyzing just purchased $100 million worth of preferred stock that was paying a 9% yield [we’ll talk more about preferred stock later]. You could rightly assume the company would receive $9 million a year in dividends on the preferred. If the company had a tax rate of, say, 35%, you may assume that $3.15 million of these dividends are going to be paid to the Uncle Sam. In truth, corporations get an exemption on 70% of the dividends they receive from preferred stock [individuals do not enjoy this luxury]. Hence, only $2.7 million of the $9 million in dividends would be subject to taxation. Don’t you love this stuff?

For your reference, here is a list of the corporate tax brackets from smbiz.com. It would serve you well to memorize them:

Corporate Income Tax Rates--2002, 2001, 2000, 1999, & 1998

Taxable income over Not over Tax rate

$ 0 $ 50,000 15%

50,000 75,000 25%

75,000 100,000 34%

100,000 335,000 39%

335,000 10,000,000 34%

10,000,000 15,000,000 35%

15,000,000 18,333,333 38%

18,333,333 .......... 35%

Minority Interests on the Income StatementIf Federated Department Stores [the owner of Macy’s and Bloomingdales] purchased five percent of Saks Fifth Avenue, Inc., common sense tells us that Federated would be entitled to five percent of Saks’ earnings. How would Federated report their share of Saks’ earnings on their income statement? It depends on the percentage of the company’s voting stock Federated owned.

• Cost Method (If Federated owned 20% or less):The company would not be able to report its share of Saks’ earnings, except for the dividends it received from the Saks stock. The asset value of the investment would be reported at the lower of cost or market value on the balance sheet. What does that mean?

If Federated purchased 10 million shares of Saks stock at $5 per share [for a total cost of $50 million], it would record any dividends received on its income statement, and add $50 million to the balance sheet under investments. If Saks rose to $10 per share, the 10 million shares would be worth $100 million [$10 per share x 10 million shares = $100 million]. However, the balance sheet would continue to list the ‘value’ of those 10 million shares at $50 million.

On the other hand, if the stock dropped to $2.50 per share, thus reducing the investments to $25 million, the balance sheet value would be written down to reflect the lower price.

• Equity Method (If Federated owned 21-49%):In most cases, Federated would include a single-entry line on their income statement reporting their share of Saks’ earnings. For example, if Saks earned $100 million and Federated owned 30 percent, they would include a line on the income statement for $30 million in income [30% of $100 million], even if these earnings were never paid out as dividends [meaning they never actually saw $30 million].

• Consolidated Method (If Federated owned 50+%):The company would be required to include all of the revenues, expenses, tax liabilities, and profits of Saks on the income statement. It would then include an entry that deducted the percentage of the business it didn’t own. If Federated owned 65% of Saks, it would report the entire $100 million in profit, and then include an entry labeled minority interest that deducted the $35 million [35%] of the profits it didn’t own.

The Importance of Unreported or Look Through EarningsYou’ll notice that the cost method, which applies to holdings under 20%, only allows the company to report the cash it actually receives in the form of dividends as income. This can be misleading. If your company owned 15% of Microsoft, you would never see a dime in dividends, although your 15% share of the earnings was being reinvested in the business on your behalf by management. Those earnings will subsequently lead to long-term rise in the value of your stock holding, and are therefore very important to your economic future.

Don’t believe it? Say you inherit a business that your great-grandfather founded a century ago. At the end of every year, he used some of the business’ profits to buy shares of Thomas Edison’s company, General Electric. By the time the company came under your control in 2002, it owned 19% of GE’s common stock [1,888,600,000 shares]. General Electric paid a dividend that year of $0.72 per share. According to GAAP accounting rules, your business could only report the $1,359,792,000 in dividends you received.

However, the year before, General Electric had actually made a profit of $14.6 billion, of which, nineteen percent indirectly belonged to you. Although you could only report $1.36 billion in dividends, you actually have a legal ownership to $2.774 billion in the company’s earnings ($1.36 billion were paid out to you as dividends, with the remaining $1.4 billion retained by GE). This means that you were not allowed to report more than $1.4 billion in earnings that indirectly belonged to you. The general logic states that because you never see that money, it shouldn’t count as income. This is both misinformed and dangerous. The entire $2.774 billion belongs to you. The portion of the earnings that were not paid out will be reinvested into GE’s business and subsequently result in a rise in the stock price. If someone were to value the business, they would include the entire $2.774 billion in their calculation because the entire amount was working to your economic benefit.

Famed investor Warren Buffett referred to these unreported profits as look-through earnings. The successful investor strives to put together a portfolio with the highest possible look-through earnings for each dollar invested. This will result in market-beating returns. In his 1980 Letter to Shareholders of Berkshire Hathaway, Buffett explained that Berkshire’s income statement was reporting less than half of what the company’s true economic earnings were:

“Our holdings in this [20% or less] category of companies [has] increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly attractive opportunities in the common stock area. The large increase in such holdings, plus the growth of earnings experienced by those partially-owned companies, has produced an unusual result; the part of ‘our’ earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings “iceberg” to appear above the surface, in plain view.”

Thus, you must add the non-reportable earnings of a company’s partially owned businesses back into the income statement to come up with an accurate estimate of economic earnings.

Continuing / Ongoing Operations vs. Discontinued OperationsIn the 1990’s, Viacom, owner of MTV, VH1, and Nickelodeon, purchased Paramount Studios. To pay for the acquisition, Viacom took on a large amount of debt. The company’s Chairman, Sumner Redstone, began selling assets and businesses the company owned in order to help pay down debt.

Simon & Schuster, a major book publisher, was one of the businesses Viacom decided to let go, ultimately selling it to British media group Pearson PLC for $4.6 billion dollars. How did the deal affect the company’s revenue and earnings?

This is where discontinued and ongoing operations come to the rescue. As soon as Viacom sold Simon, it had a pile of cash from the buyer. However, it lost all of the revenue and profit the publisher generated. Viacom’s management must somehow warn investors, “Hey, Simon generated [X amount] of our profit and revenue. Since we no longer own the business, you can’t plan on us earning this revenue / profit next year”. To do that, the Viacom puts an entry on their income statement called “Discontinued Operations”. This shows investors money that was earned from businesses that won’t be part of the company’s holdings for very much longer.

Continuing operations are the businesses the company expects to be engaged in for the foreseeable future.

Net Income from Continuing OperationsAfter all of these expenses are deducted, the investor is left with a figure called net income from continuing operations. This is a calculation of the profit its continuing operations generated during the period.

Net Income from Discontinued OperationsThe amount shown on the income statement under discontinued operations is the profit made during the period from the businesses that will not be a part of the company in the future.

Accounting ChangesGAAP accounting rules give management a large amount of leeway in determining how to report their earnings to shareholders. At times, a company may opt to change the way it has accounted for a particular item in the past, which will have the affect of increasing or decreasing the amount of reportable earnings although the company has not actually made or lost more money.

Management is required to disclose accounting changes in SEC filings. It is tremendously important that you determine if the change was necessary or simply a maneuver to inflate the amount of profit reported to shareholders.

Net IncomeThe net income is the total profit the business made for the period before required dividend payments on the company’s preferred stock.

Preferred Stock and Other AdjustmentsPreferred stock is a mix between regular common stock and a bond. Each share of preferred stock is normally paid a guaranteed, relatively high dividend and has first dibs over common stock at the company's assets in the event of bankruptcy. In exchange for the higher income and safety, preferred shareholders miss out on large potential capital gains [or losses]. Owners of preferred stock generally do not have voting privileges.

The terms of preferred shares can vary widely, even when issued by the same company. Some of the many different kinds of preferred stock available are: adjustable rate preferred stock, convertible preferred stock, first preferred stock, participating preferred stock, participating convertible preferred stock, prior preferred stock, and second preferred stock. [For more information, read the remainder of 09/16/02 article Preferred Stock and Individual Investors].

The dividends paid to preferred shares are deducted as an expense because they are required payments, unlike the common stock dividend which is just a divvying-up part of the profits.

Net Income Applicable to Common SharesThe net income applicable to common shares figure is the bottom-line profit the company reported. To get the basic earnings-per-share [Basic EPS] figure, analysts divide the net income applicable to common by the total number of shares outstanding.

The last line, at the bottom of the income statement is the amount of money the company purports to have made (net income, total profit, or reportable earnings; it’s all the same). Hence the cliché, “what’s the bottom line?”

Net Profit MarginThe profit margin tells you how much profit a company makes for every $1 it generates in revenue. Profit margins vary by industry, but all else being equal, the higher a company’s profit margin compared to its competitors, the better. Several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales. While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation, to give an idea of how much money the company made before

paying out to minority “owners”. Either way is acceptable, although you must be consistent in your calculations. All companies must be compared on the same basis.

Option 1: Net income after taxes-------------------------- (divided by) --------------------------

Revenue

Option 2: Net income + minority interest + tax-adjusted interest-------------------------- (divided by) --------------------------

Revenue

In some cases, lower profit margins represent a pricing strategy.  Some businesses, especially retailers, may be known for their low-cost, high-volume approach.  In other cases, a low net profit margin may represent a price war which is lowering profits, as was the case in the computer industry in 2000.

Net Profit Margin ExampleIn 2002, Donna Manufacturing sold 100,000 widgets for $5 each, with a COGS of $2 each.  It had $150,000 in operating expenses, and paid $52,500 in taxes.  What is the net profit margin?

First, we need to find the revenue or total sales.  If Donna's sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue.  The company's cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs.  This leaves a gross profit of $300,000 [$500k revenue - $200k COGS].  Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes.  Subtracting the tax bill of $52,500, we are left with a net profit of $97,500.

Plugging this information into our formula, we get:

$97,500 net profit--------------(divided by)--------------

$500,000 revenue

The answer, 0.195 [or 19.5%], is the net profit margin.  Keep in mind, when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you; your only job is to plug them into the formula.  [Why then did I make you go to all the work?  I just wanted to make sure you've retained everything we've talked about thus far!]

Cherry Pie: Basic vs. Diluted Earnings per ShareWhen you analyze a company, you have to do it on two levels, the “whole company” and the “per share”. If you decide ABC, Inc. is worth $5 billion as a whole, you should be able to break it down by simply dividing the $5 billion price tag by the number of shares outstanding. Unfortunately, it isn’t always that simple.

Think of each business you analyze as a cherry pie and each share of stock as a piece of that pie. All of the company’s assets, liabilities, and profits are represented by the pie as a whole. ABC’s pie is worth $5 billion. If the baker [management] slices the pie into 5 pieces, each piece would be worth $1 billion [$5 billion pie divided into 5 pieces = $1 billion per slice]. Obviously, any intelligent connoisseur of pastries would want to keep the baker from making too many slices so his or her piece was as big as possible. Likewise, an ambitious investor hungry for returns is going to want to keep the company from increasing the number of shares outstanding. Every new share management issues decreases the investor’s “piece” of the assets and profits a tiny bit. Over time, this can make a huge difference in how much the investor gets to eat.

“How can management increase the number of shares outstanding?” you may ask. There are four big knives [perhaps “cleavers” would be a more appropriate term] in any management’s drawer that can be used to add increase the number of shares outstanding: stock options, warrants, convertible preferred stock, and secondary equity offerings [all sound more complicated than they are]. Stock options are a form of compensation that management often gives to executives, managers, and in some cases, regular employees. These options give the holder the right to buy a certain number of shares by a specific date at a specific price. If the shares are “exercised” the company issues new stock. Likewise, the other three cleavers have the same affect – the potential to increase the number of shares outstanding.

This situation leaves Wall Street with the problem of how much to report for the earnings per share figure. In response, they came up with two sets of EPS numbers: basic and diluted. The basic figure is the total earnings per share based on the number of shares outstanding at the time. The diluted earnings per share figure reveals how much profit per-share a business would have made if all stock options, warrants, convertibles, etc. were invoked and the additional shares increased the total shares outstanding. The percentage of a company that is represented by these possible share dilutions is called “hang”.

Although ABC may have 5 shares outstanding today, it may actually have the potential for 15 shares outstanding during the next year. Valuation on a per-share basis should reflect the potential dilution to each share. Although it is unlikely all of the potential shares will be issued [the stock market may fall, meaning a lot of executives won’t exercise the stock options, for example], it is important that you value the business assuming all possible dilution that can take place will take place. This practiced conservatism can mean the difference between mediocre and spectacular returns on your investment.

Below is an excerpt from Intel’s 2001 income statement. 

IntelExcerpt – 2001 Annual Report

Earnings per share from continuing operations

2001 2000

Basic $.19 $1.57

Diluted $.19 $1.51

     

In 2000, the difference between Intel’s basic and diluted EPS amounted to around $0.06. If you consider the company has over 6.5 billion shares outstanding, you realize that dilution is taking more than $390 million in value from current investors and giving it to management and employees.

Clandestine Boarding on DishonestySome companies don’t include the possible share dilution from options that are “underwater”. This occurs when an employee owns options to buy shares at a certain price, and due to a sudden drop in stock

market value, the option is below the exercise price. If [and this is a big if], the stock does not rise over the exercise price, the option will expire worthless. On the other hand, if the stock advances to higher levels, these options will probably be exercised, increasing the number of shares outstanding, and dilution your percentage ownership in the business.

The problem with not including these underwater options in the diluted figures is that options normally have extended life [in some cases around 10 years]. In that time, it is very likely if not certain that some of those options will become valuable once the company’s stock price rises.

Here’s an example from Abercrombie & Fitch’s 10K:

Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options’ exercise prices were greater than the average market price of the underlying shares.

As you analyze companies, you must keep your eye out for such border-line deceptive practices as they are widespread and common occurrence.

Share Repurchase ProgramsJust as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Below is a reprint of an article I published on June 4, 2001.

Stock Buybacks – The Golden Egg of Shareholder Value“Overall growth is not nearly as important as growth per share…”

All investors have no doubt heard of corporations authorizing share buyback programs. Even if you don't know what they are or how they work, you at least understand that they are a good thing [in most situations]. Here are three important truths about these programs - and most importantly, how they make your portfolio grow.

Principle 1: Overall Growth is not nearly as important as Growth per Share

Too often, you'll hear leading financial publications and broadcast talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow. Growth per share is.

A simplified example may help. Let's look at a fictional company:

Eggshell Candies, Inc.$50 per share

100,000 shares outstanding-------------------------------------------

Market Capitalization: $5,000,000

This year, the company made a profit of $1 million dollars.==================================

In this example, each share equals .001% of ownership in the company. [100% divided by 100,000 shares.]

Management is upset by the company's performance because it sold the exact same amount of candy this year as it did last year. That means the growth rate is 0%! The executives want to do something to make the shareholders money because of the disappointing performance this year, so one of them suggests a stock buyback program. The others immediately agree; the company will use the $1 million profit it made this year to buy stock in itself.

The very next day, the CEO goes and takes the $1 million dollars out of the bank and buys 20,000 shares of stock in his company. [Remember it is trading at $50 a share according to the information above.] Immediately, he takes them to the Board of Directors, and they vote to destroy those shares so that they no longer exist. This means that now there are only 80,000 shares of Eggshell Candies in existence [instead of the original 100,000].

What does that mean to you? Well, each share you own no longer represents .001% of the company... it represents .00125% of the company... that's a 25% increase in value per share! The next day you wake up and find out that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the company didn't grow this year, you still made a twenty five percent increase on your investment! This leads to the second principle.

Principle 2: When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater percentage of equity in the company.

If a shareholder-friendly management such as this one is kept in place, it is possible that someday there may only be 5 shares of the company, each worth one million dollars. When putting together your portfolio, you should seek out businesses that engage in these sort of pro-shareholder practices and hold on to them as long as the fundamentals remain sound. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 in recent months. That is long term value!

Principle 3: Stock Buybacks are not good if the company pays too much for its own stock!

Even though buybacks can be huge sources of long-term profit for investors, they are actually harmful if a company pays more for its stock than it is worth. In an overpriced market, it would be foolish for management to purchase equity at all [even in itself]. Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market swung the other way and is trading below its true value, shares of the company can be bought back up at a discount - giving shareholders maximum benefit.

Remember, "even the best investment in the world isn't a good investment if you pay too much for it".

Return on Equity – ROEOne of the most important profitability metrics is return on equity [or ROE for short]. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder’s equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher you can get the “return” on your equity, in this case 5%, the better.

The formula for Return on Equity is:

Net Profit----------(divided by)----------

Average Shareholder Equity for Period 

Martha Stewart Living Omnimedia, Inc.Excerpt – 2001 Consolidated Balance Sheet

(in thousands except per share data) 2001 2000

Total Shareholders’ Equity 222,192 196,116

Total liabilities and shareholders’ equity 311,621 287,414

     

 

Martha Stewart Living Omnimedia, Inc.Excerpt – 2001 Consolidated Balance Sheet

(in thousands except per share data) 2001 2000

Total Shareholders’ Equity 222,192 196,116

Total liabilities and shareholders’ equity 311,621 287,414

     

Now that we have the income statement and balance sheet in front of us, our only job is to plug a the numbers into our equation. The earnings for 2001 were $21,906,000 [because the amounts are in thousands, take the figure shown, in this case $21,906, and multiply by 1,000. Almost all publicly traded companies short-hand their financial statements in thousands or millions to save space]. The average shareholder equity for the period is $209,154,000 [$222,192,000 + 196,116,000 divided by 2].

Let’s plug the numbers into the formula.

$21,906,000 earnings-------------(divided by) -------------

$209,154,000 average shareholder equity for period

The answer is 0.1047, or 10.47%. This 10.47% is the return that management is earning on shareholder equity. Is this good? For most of the twentieth century, the S&P 500 [a measure of the biggest and best public companies in America] averaged ROE's of 10 to 15%. In the 1990’s, the average return on equity was in excess of 20%. Obviously, these twenty-plus percent figures probably won’t endure forever. In the past two years alone, small and large corporations alike have issued repeated earnings revisions, warning investors they will not meet analysts’ quarterly and / or annual estimates.

Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO’s in their annual reports about, “achieving record earnings”. Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report “record earnings” because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management’s fiscal adeptness than the annual earnings per share.

The return on equity calculation can be as detailed as you desire. Most financial sites and resources calculate return on common equity by taking the income available to the common stock holders for the trailing [most recent] twelve months and dividing it by the average shareholder equity for the most recent five quarters. Some analysts will actually “annualize” the recent quarter by simply taking the current income and multiplying it by four. The theory is that this will equal the annual income of the business. In many cases, this can lead to disastrous and grossly incorrect results. Take a retail store such as Lord & Taylor or American Eagle, for example. In some cases, fifty-percent or more of the store’s income and revenue is generated in the fourth quarter during the traditional Christmas shopping period. An investor should be exceedingly cautious not to annualize the earnings for seasonal businesses.

Calculating Asset TurnoverThe asset turnover ratio calculates the total sales [revenue] for every dollar of assets a company owns. To calculate asset turnover, take the total revenue and divide it by the average assets for the period studied. [Note: you should know how to do this. In lesson 3 we took the average inventory and receivables for certain equations. The process is the same; take the beginning assets and average them with the ending assets. If XYZ had $1 in assets in 2000 and $10 in assets in 2001, the average asset value for the period is $5 because $1+$10 divided by 2 = $5]. A quick exercise would benefit your understanding.

Asset Turnover:

Total Revenue---------(divided by) ---------Average assets for period

 

Alcoa2001 Income Statement Excerpt

Period Ending: Dec 31, 2001 Dec 31, 2000 Dec 31, 1999

Total Revenue $22,859,000,000

$23,090,000,000

$16,447,000,000

Cost Of Revenue $17,857,000,000

$17,342,000,000

$12,536,000,000

Gross Profit $5,002,000,000

$5,748,000,000 $3,911,000,000

 

Alcoa2001 Balance Sheet Excerpt

  2001

2000

1999

Long Term Assets

     

Long Term Investments $1,428,000,000

$1,072,000,000 $673,000,000

Property, Plant and Equipment

$11,982,000,000

$14,323,000,000

$9,133,000,000

Goodwill $9,133,000,000

$6,003,000,000 $1,328,000,000

Intangible Assets $674,000,000

$821,000,000 $117,000,000

Accumulated Amortization N/A

N/A N/A

Other Assets N/A

N/A N/A

Deferred Long Term Asset Charges

$1,746,000,000

$1,894,000,000 $1,015,000,000

Total Assets $28,355,000,000

$31,691,000,000

$17,066,000,000

In 2001 and 2000, Alcoa [Aluminum Company of America] had $28,355,000,000 and $31,691,000,000 in assets respectively, meaning there were average assets of $30,023,000,000 [$28.355 billion + $31.691 billion divided by 2 = $30.023 billion]. In 2001, the company generated revenue of $22,859,000,000. When applied to the asset turn formula, we find that Alcoa had a turn rate of .76138. That tells you that for every $1 in assets Alcoa owned during 2001, it sold $.76 worth of goods and services.

$22,859,000,000 revenue---------(divided by) ---------

$30,023,000,000 average assets for period

There are several general rules that should be kept in mind when calculating asset turnover. First, asset turnover is meant to measure a company’s efficiency in using its assets. The higher the number, the better [although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses.] The higher a company's asset turnover, the lower its profit margin tends to be [and visa versa].

Return on AssetsWhere asset turnover tells an investor the total sales for each $1 of assets, return on assets [or ROA for short] tells an investor how much profit a company generated for each $1 in assets. The return on assets figure is also a sure-fire way to gauge the asset intensity of a business. Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light (in the case of a software companies, once a program has been developed, employees simply copy it to a five-cent disk, throw an instruction manual in the box, and mail it out to stores).

Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal [the shareholders’ capital plus short and long-term borrowed funds]. Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, it the return on assets and return on equity figures will be the same.

There are two acceptable ways to calculate return on assets.

Option 1:Net Profit Margin x Asset Turnover

Option 2:Net income

-----------(divided by) -----------Average Assets for the Period

The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies]. 

Johnson Controls2001 Income Statement Excerpt

Period Ending: Sep 30, 2001 Sep 30, 2000 Sep 30, 1999

Total Revenue $18,427,200,000

$17,154,600,000

$16,139,400,000

Cost Of Revenue $478,300,000 $472,400,000 $419,600,000

Preferred Stock and Other Adjustments

($8,800,000)

($9,800,000) ($13,000,000)

Net Income Applicable to Common Shares

$469,500,000 $462,600,000 $406,600,000

 

Johnson Controls2001 Balance Sheet Excerpt

  2001

2000

1999

Long Term Assets

     

Long Term Investments $300,500,000 $254,700,000 $254,700,000

Property, Plant and Equipment $2,379,800,000

$2,305,000,000

$1,996,000,000

Goodwill $2,247,300,000

$2,133,300,000

$2,096,900,000

Intangible Assets N/A N/A N/A

Accumulated Amortization N/A

N/A N/A

Other Assets $439,900,000 $457,800,000 $457,700,000

Deferred Long Term Asset Charges

N/A N/A N/A

Total Assets $9,911,500,000

$9,428,000,000

$8,614,200,000

Total Stockholder Equity $2,985,400,000

$2,576,100,000

$2,270,000,000

Net Tangible Assets $738,100,000 $442,800,000 $173,100,000

The first option requires that we calculate net profit margin and asset turnover. In most of your analyses, you will have already calculated these figures by the time you get around to return on assets. For illustrative purposes, we’ll go through the entire process using Johnson Controls as our sample business.

Our first step is to calculate the net profit margin. We divide $469,500,000 [the net income] by the total revenue of $18,427,200,000. We come up with 0.025 (or 2.5%).

We now need to calculate asset turnover. We average the $9,911,500,000 total assets from 2001 and $9,428,000,000 total assets from 2000 together and come up with $9,669,750,000 average assets for the

one-year period we are studying. Divide the total revenue of $18,427,200,000 by the average assets of $9,660,750,000. The answer, 1.90, is the total number of asset turns. We now have both of the components of the equation to calculate return on assets:

.025 [net profit margin] x 1.90[asset turn] = 0.0475, or 4.75% return on assets

The second option for calculating ROA is much shorter. Simply take the net income of $469,500,000 divided by the average assets for the period of $9,660,750,000. You should come out with 0.04859, or 4.85%. [Note: You may wonder why the ROA is different depending on which of the two equations you used. The first, longer option came out to 4.75%, while the second was 4.85%. The difference is due to the imprecision of our calculation; we truncated the decimal places. For example, we came up with asset turns of 1.90 when in reality, the asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as possible.

Is a 4.75% ROA good for Johnson Controls? A little research on MSN Money Central shows that the average ROA for Johnson’s industry is 1.5%. It appears Johnson’s management is doing a much better job than the competitors. This should be welcome news to investors.

Projecting Future EarningsWe will save most of the discussion on future earnings for our later lesson focusing exclusively on valuing a business. As a caveat, let’s cover some of the basic principles:

1. The greatest indicator of the future is the past. If a company has grown at 4% for the past ten years, it is very unlikely it will start growing 6-7% in the future [short of some major catalysts]. You must remember this, and guard against optimism. Your financial projections should be slightly pessimistic at worst, outright depressing at best. Being masochistic in finance can be very profitable. It’s always the Pollyanna’s that get creamed.

2. Companies involved in cyclical industries such as steel, construction, and auto manufacturers are notorious for posting $5 EPS one year and -$2.50 the next. An investor must be careful not to base projections off the current year alone. He / she would be best served by averaging the earnings over the past tens years, and basing coming up with a valuation based on that figure. For more information, read Valuing Cyclical Stocks: Assigning Intrinsic Value to Businesses with Unsteady Earnings.

Formulas, Calculations and Ratios for the Income StatementYou’ve learned how to analyze an income statement! In segment two, we are going to look at the income statements for three companies in the S&P 500. Below is a list of the equations we have covered in this lesson. You should memorize them as soon as possible.

Gross Margin: gross profit ÷ revenueR&D to Sales: R&D expense ÷ revenueOperating Margin: operating income ÷ revenue [also known as operating profit margin]Interest coverage ratio: EBIT ÷ interest expenseNet Profit Margin: net income [after taxes] ÷ revenueReturn on Equity (ROE): net profit ÷ average shareholder equity for the periodAsset Turnover: revenue ÷ average assets for periodReturn on Assets: Net profit margin * asset turnover or net income ÷ total average assets for the period1Working Capital per Dollar of Sales: Working Capital ÷ Total Sales1Receivable Turnover: Net Credit Sales ÷ Average Net Receivables for the Period1Inventory Turnover: Cost of Goods Sold ÷ Average Inventory for the Period

1These calculations were discussed in Investing Lesson 3: Analyzing a Balance Sheet. They require both the balance sheet and the income statement to calculate.

Putting it all TogetherAt this point, you should have the ability to understand the most common entries on the income statement, calculate and compare gross, operating, and profit margins, examine depreciation policies and put competitors in the same industry on a comparable basis, calculate ROE, ROA, and asset turnover, have a respectable understanding of how businesses account for minority-owned stakes in other companies, explain the difference between basic and diluted earnings-per-share, appreciate share repurchase programs when stock prices are falling, despise share dilution, be able to explain what “underwater” options are, and discuss why EBITDA is a worthless metric. Congratulations! I hope you feel it was time well spent. Although there is always more to learn, you are further ahead than a majority of people who own stocks, mutual funds, or bonds.

In the future, it may help to think of the income statement as following this general outline:Revenue – Cost of Revenue = Gross ProfitGross Profit – All Operating Expenses = Operating ProfitOperating Profit – Interest Expense, Income Taxes, and Depreciation = Net Income fromContinuing OperationsNet Income from Continuing Operations – Nonrecurring events [extraordinary items, discontinued operations, etc] = net incomeNet income – preferred stock and other adjustments = net income applicable to common shares

Abercrombie and Fitch - 2001 Annual Income StatementNow that you have come this far, we are going to analyze three income statements.  First on our list is Abercrombie and Fitch, a specialty clothing retailer that has made a name for itself by selling the 'college experience'.  As of February 2, 2002, the company operated a total of 491 stores [309 Abercrombie & Fitch stores, 148 abercrombie stores [tailored to a younger audience], and 34 Hollister Co. stores.]  Notice that I've included a copy of the balance sheet so we can calculate return on equity, return on assets, etc.  All financials are taken from the company's 2001 annual report, pages 19 and 20. 

Abercrombie & FitchConsolidated Statements of Income

(Thousands except per share amounts)

Fiscal year ended 2001

2000

1999

Net Sales $1,364,853

$1,237,604

$1,030,858

Cost of Goods Sold, Occupancy and Buying Costs

806,816

728,229

580,475

Gross Income 558,034

509,375

450,383

General, Administrative and 286,576

255,723

209,319

Store Operating Expense

Operating Income 271,458

253,652

242,064

Interest Income, Net (5064)

(7,801)

(7,270)

Income Before Income Taxes 276,522

261,453

249,334

Provision for Income Taxes 107,850

103,320

99,730

Net Income $168,672

$158,133

$149,604

Net Income Per Share:

     

Basic $1.70

$1.58

$1.45

Diluted $1.65

$1.55

$1.39

The accompanying Notes are an integral part of these Consolidated Financial Statements 

Abercrombie & FitchConsolidated Balance Sheets

(Thousands)

  February 2, 2002

February 3, 2001

Assets

   

Current Assets    Cash and Equivalents $167,664 $137,581Marketable Securities 71,220 -

Receivables 20,456 15,829Inventories 108,876 120,997

Store Supplies 21,524 17,817Other 15,455 11,338

Total Current Assets 405,195 303,562Property and Equipment, Net 365,112 278,785

Deferred Income Taxes - 6,849Other Assets 239 381Total Assets $770,546 $589,577

     Liabilities and Shareholders' Equity    

Current Liabilities    Accounts Payable $31,897 $33,942Accrued Expenses 109,586 101,302

Income Taxes Payable 22,096 21,379Total Current Liabilities 163,579 156,623Deferred Income Taxes 1,165 -

Other Long-Term Liabilities 10,368 10,254Shareholder's Equity    

Common Stock - $.01 par value 1,033 1,033Paid-In Capital 141,394 136,490

Retained Earnings 519,540 350,868  661,967 488,391

Less: Treasury Stock, at Average Cost

(66,533) (65,691)

Total Shareholders' Equity 595,434 422,700Total Liabilities and Shareholders' Equity

770,546 589,577

     

The accompanying Notes are an integral part of these Consolidated Financial Statements

Gross MarginThe first thing we do is calculate the company's gross margin.  Taking the gross profit of $558,034 and dividing it by $1,364,853, we come up with .40996, or almost 41%.  Applying the same calculation to previous years, we find that in 2002, company's gross margin was 41.2%, compared with 43.7% in 1999.  As a potential owner of the business, you want to find out why the gross margin is falling, and if the trend is expected to continue.  If the industry is hit hard by economic conditions, calculate the gross margins over the past three years for Abercrombie's competitors [such as Pacific Sunwear, Gap, or American Eagle] to see if they are experiencing the same problem.

Operating Margin:We calculate the operating margin as 19.9% during 2001, 20.5% in 2000, and 23.5% in 1999.

Interest Coverage Ratio:You will notice that the interest income is recorded as net.  If you think back to the lesson, you should remember that this means the total interest expense and interest income were added together to offset

one another and the resulting figure recorded.  In Abercrombie's case, the company recorded -5,064 in interest.

Using this information to calculate the interest coverage ratio, we take the earnings before interest and taxes [EBIT], of $271,458, and divide it by the total interest expense of $5,064.  The answer is 53.60.  What does this mean?  The company can afford to make its interest payments 53+ times.  Obviously, it is going to have no problem making its relatively miniscule payments.

Net Profit Margin:In 2001, Abercrombie had a profit margin of 12.4%.  In 2000, the profit margin was 12.8%, while in 1999, it stood at 14.5%.  Once again, this doesn't mean much unless you compare it to the profit margins of competitors.  Even then, it may be inaccurate because of pricing strategy [for instance, Neiman Marcus may have a slightly higher profit margin than Wal-Mart, but that is because of the two retailers have different pricing strategies and business models.]

Return on Equity - ROEHere's where we get to the juice.  To quickly calculate Abercrombie's return on equity, take the average shareholders' equity [$595,434+422,700 ÷ 2] of $509,067 and divide it into the net profit of $168,672.  The answer, .3313, or 33.13%, is the return that management is earning on the retained profits.  Obviously, your pocketbook will be much faster enriched if you allow the company to retain all of the profits instead of paying them out as dividends [can you reinvest the earnings at 33%?  Probably not!]

If both Abercrombie and a competitor were selling for ridiculously cheap [say 3 times earnings], you would want to go with the business that was generating the highest return on shareholder equity.  Considering the average corporation earns between 10 and 15% on its equity, Abercrombie's high ROE should make your mouth water.

Asset TurnoverTaking Abercrombie's average assets of $680,061.5 [$770,546+$589,577 ÷ 2], and dividing it into the total revenue of $1,364,853, we find the company has an asset turn of 2.0.  There are several general rules that should be kept in mind when calculating asset turnover. First, asset turn is meant to measure a company’s efficiency in using its assets. The higher the number, the better [although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses.] The higher a company's asset turnover, the lower its profit margin tends to be [and visa versa].

Return on AssetsMultiplying the 12.4% net profit margin by the 2.0 asset turn, we get .248, or 24.8% return on assets.  Using the second formula, we divide the net income of $168,672 by the $680,061.5 average assets, which we discover is .248 or 24.8%.

Share dilutionAs a conservative investor, you should base your valuation on the diluted earnings per share.  Unfortunately, if you remember back to our discussion on share dilution, you haven't forgotten the clandestine tactics Abercrombie took by not including all possible stock option dilution in the diluted EPS figure:

From Abercrombie & Fitch’s 10K:

Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options’ exercise prices were greater than the average market price of the underlying shares.

If you believe that Abercrombie is undervalued at the current market price and therefore expect the stock to rise, some of these underwater options may become exercisable, reducing the EPS even further.  You would be wise to make a provision for these in your valuation [for instance, if you take the net income of

$168,672,000 and divide it by the diluted EPS of $1.65, you can see that management estimates the possibility of a total of 102,225,454+ shares outstanding.  You may want to add the 5,630,000 underwater shares to this figure, making the fully diluted outstanding shares stand at around 107,855,454.  Now, taking the net income of $168,672,000 and dividing it by the true fully diluted figure, you would get diluted EPS of $1.56 instead of $1.65.]

Although there is a possibility of these shares not being exercised, practiced conservatism can make a big difference to your pocketbook over time.

Final Thoughts on the CompanyA quick look at the income statement shows that sales, gross profit, operating profit, and the basic and diluted EPS have increased steadily for the past few years, even though the gross, operating, and profit margins have fallen slightly.  These factors, combined with the high return on shareholders' equity should leave an investor fully satisfied with the business.  Management has clearly created shareholder value by increasing the amount of equity on the balance sheet, and reinvesting profits at a high rate of return.  If the company's shares were to ever trade low enough, an enterprising investor should have no problem holding Abercrombie in their portfolio if the current conditions persists.

Brown SafetyBrown Safety* [a fictional company], is the manufacturer of safety products such as chemical goggles, fire extinguishers, safety ropes, and scaffolding for construction jobs.  In 2001, the company reported record EPS of $2.79, up from just $0.03 the year before. 

Brown SafetyConsolidated Statements of Income

(Thousands except per share amounts)

Fiscal year ended 2001

2000

1999

Net Sales $5,000

$10,000

$20,000

Cost of Goods Sold, Occupancy and Buying Costs

2,500

5,000

10,000

Gross Income 2,500

5,000

10,000

General, Administrative and Store Operating Expense

1,000

1,000

1,000

Operating Income 1,500

4,000

9,000

Interest Income, Net 0

0

0

Income from Continuing Operations Before Income

Taxes

1,500

4,000

9,000

Investment Income $350,000

0 0

Provision for Income Taxes 70,510 600 1,350

Net Income $279,490

3,400 7,650

Net Income Per Share:

     

Basic $2.79 $0.03 $0.08

Diluted $2.79 $0.03 $0.08

       

The accompanying Notes are an integral part of these Consolidated Financial Statements100,000 shares outstanding

Those of you who looked closely at Brown's income statement may have caught on to my trick.  Excellent job.  If you didn't, let me explain.

Deteriorating Core OperationsIn 1999, Brown had a 38.25% profit margin.  In 2000, Brown had a 34.0% profit margin.  In 2002, Brown had a 25.5% profit margin.  Don't believe me?  Look close at the income statement.  You will see that each year, the total profit and revenues have been cut in half, while SG&A expenses remained at a steady $1,000 [which caused the decreasing profit margin].  In the most recent year, Brown only made $1,500

pre-tax from its continuing operations.  Assuming a 15% tax rate, the net profit would have worked out to $1,275 had it not been for investment income.

In the most recent year, Brown realized $350,000 in investment income.  Without this one-time boost to earnings, the company would have reported EPS of just over $0.01.  To drive home what these means, assume Brown is trading at $5 per share [any number will do, this is solely for illustrative purposes].  A well-meaning but less-than-astute investor may scan the stock tables one morning and see that Brown is trading at a a p/e ratio of 1.8 [$5 per share ÷ $2.79 EPS].  He gets excited, throws up his hands and calls his broker to buy as many shares as possible.  At this rate, he'd be earning 55.8% on his investment!

Unfortunately, in a year or so, the investor will have a very unpleasant surprise.  If the current decline in the core business persists, the company will report earnings of $0.005 [that's half a penny!] per share.  This makes the p/e ratio 1,000!  Instead of a 55.8% return on his investment in 2002, the shareholder will earn a pathetic .001%.  He is going to lose a major portion, if not all, of his investment unless the business has a large portfolio of stocks and bonds that it can distribute to shareholders or continue selling for cash [as was the case of the Northern Pipe Line, an oil transportation company managed by the Rockefellers.  The stock was trading at $65 per share when Benjamin Graham studied the balance sheet and realized the company had bond holdings worth $95 for each share.  The value investor tried to convince management to sell the portfolio off, but they refused.  Shortly thereafter, he waged a proxy war and secured a spot on the Board of Directors.  The company sold its bonds off and paid a dividend in the amount of $70 per share.]

The MoralWhy the over-simplified example?  There will come a day when you are analyzing a business, and on the surface, it will seem that earnings are increasing and management is doing a splendid job.  Upon closer examination, you may find that the core business is actually losing money, and all of the reported profits come from one-time events such as the sale of a business unit, real estate, intellectual property, marketable securities, or any other number of assets.  Unless you are buying a company because you believe its liquidation value is higher than its current market price, you could be in for a rude awakening when management suddenly doesn't have anything left to sell or the losses in the core business have spiraled out of control.