How to identify a stock that grow profits consistently and separate them from a pool of other stocks that fail to do so?
The answer lies in reading a stock’s statement of profit or loss, or widely known as income statement. It tells us whether or not, the stock has been profitable in a stipulated period of time. Personally, I believe this information is important as stock price movements tend to mirror stock profits over the long-term, which is a reason why value investing works.
Here is a sample of a company’s income statement:
In this article, I’ll share 5 main things on a company’s income statement so that you can interpret it easily. They are as follows:
#1: Reporting Period
From above, the financial year ended stated is 31 December 2018. As such, the statement accounts for the amount of revenues and expenses the company has made and incurred for a period of twelve months (annual report), starting from 1 January 2018 to 31 December 2018.
Beside its 2018 figures, the company would report its 2017 figures which would mostly be used for comparison purposes.
#2: How Revenues of a Company are Recorded?
Isn’t Revenues in the statement an account of how much cash the company has been collected after selling its products or services?
Not quite. It depends on the stock’s business models. To better understand this, let me share the actual definition of revenue in the world of accounting and the number of ways a company can record a revenue or sale in its accounts.
Revenue is recognised when or as a performance obligation in its agreement or contract with its customers has been satisfied.
Methods of Recognition:
In general, there are three major methods of how a company may record a sale and they would impact its financial statements (balance sheet and statement of cash flow) differently.
They are as follows:
- Method 1: If I’m a Retailer:
I collected $1 from selling a can of Pepsi. The $1 is cash sales. Thus, the sale would be recorded as follows:
- Method 2: If I’m a Manufacturer:
I secured a sale of 100,000 cans of Pepsi to a supermarket. This sales is worth $40,000. I have delivered them to the supermarket and issued a bill (invoice) where its credit terms given is 90 days. As such, the sale is recorded as follows:
Subsequently, 90 days later, the supermarket made its payments to me. As such, the cash received would be recorded as follows:
- Method 3: If I’m a Contractor
I was given a contract to construct a condominium building valued at $ 100 million. The duration of the project is three years. In its first year, I have completed 40% of this project (estimated by engineers) and have received 25% of the payment from my master builder.
Thus, my sale would be recorded as follows:
Isn’t this an eye-opener? Thus, it explains why we should study and learn about a stock’s business model before investing in its shares.
The above income statement belongs to Heineken Malaysia Bhd (HMB) which is a manufacturer (Method #2) of alcoholic beverages in Malaysia.
#3: 5 Types of Expenses
Let us focus on HMB. When running its business, HMB would incur a number of expenses. They are segregated into five different categories. The categories are as follows:
The fifth category is corporate tax expenses.
Thus, the reporting format of an income statement is as follows:
#4: 3 Profits Margins to Measure Business Performances
I have highlighted the above for investors would be focusing on these figures to find out whether or not, the stock is profitable and to also evaluate its ability in controlling costs. It involves the calculation of the three profit margins stated in the table above.
It simply means the following: From every RM 100 HMB makes in revenues,
- It is left with RM 32.20 in Gross Profits after cost of sales.
- It is left with RM 18.76 in Profits before Tax after cost of sales, business expenses and non-business expenses.
- It is left with RM 13.92 in Profits after Tax after cost of sales, business & non-business expenses, and corporate tax expenses.
Revenue > Gross Profits > Profits Before Tax > Profits After Tax
RM 100.00 > RM 32.20 > RM 18.76 > RM 13.92
#5: How to Calculate Earnings per Share (EPS) of a Stock?
In 2018, HMB has made RM 282.52 million in shareholders’ earnings.
But, how many of us can afford to buy and own 100% shareholdings of HMB to make RM 282.5 million in annual earnings?
Fortunately, as HMB is a publicly listed company, we can invest in HMB’s shares to own a portion (small fraction) of the company. Hence, we would calculate its earnings per share (EPS). It is its shareholders’ earnings on a per share basis.
From above, we are given the following:
|HMB’s Profits After Tax (100% Shareholdings)||RM 282.52 million|
|HMB’s Earnings per Share (1 Share)||RM 0.935|
How do we get the figure of RM 0.935 in EPS?
Let us take a look at Note 9 of its Notes to the Financial Statement.
From Note 9, we would learn that HMB has 302.098 million shares. Thus, EPS is calculated as follows:
EPS = Shareholders’ Earnings / No. of Ordinary Shares
HMB’s EPS (2018)
= Shareholders’ Earnings / No. of Ordinary Shares
= RM 282.52 million / 302.098 million
= RM 0.935
How much would you invest into HMB which is earning RM 0.935 a share in the year of 2018?
As I write, on 31 August 2019 (That was how I spend my Merdeka Holiday), the company is trading at RM 24.44 a share.
So, if you invest in HMB’s shares, your earnings yield is 3.83% per annum.
HMB’s Current Earnings Yield (31 August 2019)
= (Latest EPS (2018) / Current Stock Price) x 100%
= (RM 0.935 / RM 24.44) x 100%
Alternatively, most investors use P/E Ratio as a valuation tool. I’d discussed this in detail – How to Find Undervalued Stocks by Using P/E Ratio?
In short, HMB’s P/E Ratio is 26.14, which means, if you buy, you are investing as much as RM 26.14 to buy HMB for every RM 1 it earns a year.
HMB’s Current P/E Ratio (31 August 2019)
= Current Stock Price / EPS
= RM 24.44 / RM 0.935
Income statement is a document that enables us to assess a stock’s capabilities in generating profits and controlling costs. It is dangerous to invest without first reading this statement as you need it to separate a good stock that consistently grow profits from others that don’t.