How to analyze an earnings report — Part 1: The income statement

Published Mon, Oct 3 202210:06 AM EDTUpdated Mon, Oct 10 20221:45 PM EDT

One thing that separates fledgling investors from the pros is reading financial statements. For amateurs, comparing the so-called headline numbers — sales and earnings — to estimates is the full extent of research into a company, whereas in more experienced hands, they are just a starting point. If you want to become a better investor, make like a pro and digest the financials. It's the best way to truly understand a company's performance. In the lead up to the start of earnings season later this month, we've put together a five-part series to help Club members better understand all the tables and charts and how to analyze them. Here's Part 1: The income statement. Part 1: Income statement In the financial statements that companies report to the Securities and Exchange Commission and shareholders on a quarterly and annual basis, there are three main sections: the income statement, the balance statement and the cash flow statement. They are all important for different reasons. While the cash flow statement shows how much actual money a company brought in or used to run its businesses and the balance sheet displays its overall financial health, the income statement sums up a company's revenues and expenses over a period of time. Here, we'll walk through how to read and interpret the latter. The income statement gives us our best view of management's performance. How efficiently is the team running its business? How is it handling risk? Adjusting to economic headwinds? It also helps us to better analyze the top (sales) and bottom (profits) lines. Consider: A company may beat expectations on sales, but look a little deeper and you might discover it had to slash prices — increase "promotional activity" — to get there. Or a company reports better-than-expected earnings, but cut its research and development (R & D) budget to do it, thus imperiling future innovation. These are not high-quality beats. On the other hand, a company could deliver weaker earnings because it needed to invest more to ramp up production to meet strong demand. This miss isn't as bad as it looks, since the company is setting up to increase longer-term profits. At the Investing Club, we'll take that over an earnings beat at the cost of investing in the business to grow even more in the future. In terms of presentation, income statements can vary slightly company to company, but they all have the same key metrics. We'll use the recent statement from Club holding Apple (AAPL) as an example. The best way to read the statement is top to bottom. The top part focuses on sales — the money brought in — while the middle focuses on costs and expenses. The bottom is where you find earnings, which alone can't give you a clear view of management's performance. All three parts need parsing. Sales The top line represents the total dollar amount of goods and services sold in the period. Most companies will also provide some breakdown by operating segments. Apple goes a step further by breaking the sales figure into products and services, since those are the two primary sources of revenue for the company. Why you should care : There are many things a company can do to improve the bottom line. But it's often at the cost of longer-term growth, such as cutting spending on R & D or marketing. Sales, on the other hand, are harder to engineer and so speak directly to the demand for a company's products. Cost of goods sold The "COGS" line shows the direct cost to create, store and deliver products or services . The greatest input here is generally the cost of materials (and in some cases may also include an estimate of warranty costs). Why you should care : This can help us estimate how profitable a company could become as efficiencies below this line item (in the operating expense section of the income statement) improve. The greater the gross profit margin, the more flexibility a company has for other expenses — such as marketing or R & D — or to lower costs in the pursuit of greater sales volume. Gross margin This is the percentage of sales left over after accounting for COGS . In Apple's most recent earnings report, the company generated total sales of $82.96 billion and COGS came in at $47.07 billion. Subtracting the COGS from the sales, we get gross margin dollars of $35.89 billion. To calculate a gross margin, we would divide the gross margin dollars by total sales. Apple's gross margin is 43.26% (simple math: divide $35.89 by $82.96, then take the answer and move the decimal point two places to the right to represent it in percentage terms). Why you should care : This key metric of profitability can be used to monitor a company's efficiency in sourcing raw goods or, in some cases, the cost of logistics to get goods to customers. Since it includes the cost of the raw goods (found in COGS), which fluctuate from product to product, the margin also highlights the sales mix (the different streams of revenue). If the margin fluctuates, then the sales mix is something to listen for on an earnings conference call. For example, luxury products typically have higher gross margins because consumers are paying up for brand recognition. But if the margins comes down, it may mean consumers are tightening their belts and more likely to spend discretionary income on lower-priced goods. Operating expenses These costs are made up of R & D and selling, general and administrative (SG & A) costs . (Note, here is one example where we may see some variance from company to company. Club holding Amazon (AMZN), for example, explicitly states fulfillment costs as it is more relevant to understanding that business. That said, the SG & A and R & D categories are quite standard across companies.) We always want to see a healthy R & D budget because while it's an expense in a given quarter, it's the engine that drives innovation and helps a company stay competitive. SG & A may include items such as salaries, advertising, rent, utilities, marketing, legal costs, office supplies and so on — the basic expenses to keep the lights on. Also included here will be depreciation and amortization expenses. Why you should care : A good management team operates to increase efficiency and productivity. Operating expenses are the expenses most directly within their control. A team only has so much power over the cost of things like raw goods (which are related to COGS), but the items that go into operating expenses are directly within their control. By studying these expenses, especially as a percentage of revenue (SG & A divided by sales or R & D divided by sales), we can get a sense of how much operating leverage the team is getting. For example, if SG & A expenses as a percentage of sales are increasing over time, it could indicate that the return on those expenditures is diminishing and management is losing operating leverage. On the other hand, if SG & A as a percentage of revenue holds constant it tells us that we are getting similar returns on that spend, which may justify spending more as every dollar increase here leads to a proportional increase in sales. If the percentage is going down over time, then we are seeing operating leverage improve as the team is spending less per dollar of revenue on SG & A, an indication that efficiency is improving and therefore so is potential earnings power. Operating income Once we remove operating expenses from gross margin dollars , we are left with what is known as operating income. Some may also refer to this as a company's "EBIT" margin, which stands for earnings before interest and taxes. Similar to what we did with gross margin dollars, we can take this operating income, divide it by total sales and calculate the company's operating margin. In Apple's case, we would take operating income of $23.08 billion divided by sales of $82.96 billion (remember to move that decimal over) to get an operating margin of 27.82%. Why you should care : An analysis of the operating margin can tell us how efficiently management is running a company against historical standards or against others in the industry. While changes in the margin are expected from quarter to quarter, or year to year, the why behind the change is crucial. Some questions to be considered: Is too much being spent on marketing? Is enough being spent on R & D? Are fixed costs too high versus peers? Have depreciation and amortization dynamics changed? Did a company hire too many people? Some companies will report a line item before reporting operating income referred to as "EBITDA," which stands for earnings before interest, taxes, depreciation and amortization . The reason we don't find it on Apple's income statement is because EBITDA is not a GAAP measurement and Apple reports on a GAAP (generally accepted accounting principles) basis. Opinions on the usefulness of this metric are mixed. Depreciation and amortization are very real expenses. They may not require a cash outlay to realize, but eventually an asset must be replaced and that is a very real cash cost. The metric is widely used by companies and analysts and can move stock prices. We certainly use it for the Club. How much weight an investor should give to it is up for debate. On the one hand, it does provide a good means of comparing a company to peers because it can provide insight into the strength of a company's operating profitability before non-cash expenses. This helps generate a better apples-to-apples comparison across an industry to see which companies are more efficiently managing items above the EBITDA line, such as the cost of goods (COGS), SG & A, and R & D. On the other hand, it somewhat clouds the profitability profile because it attempts to focus investor attention on a profit metric without including the cost of depreciation or amortization. Other income/expenses This includes interest and dividend income, interest expenses, and other non-operating related income/expenses, such as realized gains or losses on currency hedges used to protect against swings in foreign exchange rates. Remove this from operating income or "EBIT" and we are left with "EBT" (earnings before taxes), which Apple refers to intuitively as "income before provision for income taxes." Why you should care : While less attention is usually placed on the interest and taxes part of the income statement since as it is not a major indicator of operating performance, it is worth a quick look just to ensure there are no surprises. Additionally, if there is a large fluctuation in taxes it may be worth a closer inspection just to ensure there has not been a material change in the tax burden going forward. Net income From there, we have the tax line and once we remove taxes , we are left with net income. Of course, seeing as we trade stocks based on earnings-per-share, we want a per-share number. This is simply calculated as net income divided by shares outstanding. In Apple's case, this would be $19.44 billion divided by 16.26 billion shares outstanding (in general we want the diluted share count as it incorporates any dilution that may occur from items such as convertible debt or employee compensation plans), which results in earnings of $1.20 per share. Why you should care : The primary objective of a business is to generate profits. Without a profit, the business is simply not sustainable. Moreover, earnings-per-share are used to value a business. If earnings go up, then the stock can appreciate sustainably as the multiple (calculated by dividing the price of the stock by forward next 12 months earnings estimates) placed on those earnings need not expand. Remember, stock appreciation via price-to-earnings multiple expansion is less favorable and riskier than stock price appreciation based on earnings growth. Bottom line Reading an income statement can give you an edge when it comes to determining the quality of an earnings release or when comparing a company against its peers. If you know how to read an income statement, cash flow statement, balance sheet and listen to an earnings call, after a while, you can pretty much anticipate what Wall Street analysts will say about the quarter, especially if you know what they were looking for coming into the print. Here's Part 2 in this financial statement series for the Investing Playbook, where we will go over Apple's balance sheet statement . (Jim Cramer's Charitable Trust is long AAPL and AMZN. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . 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Apple CEO Tim Cook speaks at an event at the Apple Park campus in Cupertino, California, on Sept. 7, 2022. At a presentation dubbed Far Out, Apple is set to unveil the iPhone 14 line, a fresh slate of smartwatches and new AirPods.

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