1. Value Investing: Introduction
  2. Value Investing: What Is Value Investing?
  3. Value Investing: How Stocks Become Undervalued
  4. Value Investing: Finding Undervalued Stocks
  5. Value Investing: Finding Value In Financial Reports And Balance Sheets
  6. Value Investing: Finding Value In Income Statements
  7. Value Investing: Managing The Risks In Value Investing
  8. Value Investing: Famous Value Investors
  9. Value Investing: Couch Potato Value Investing
  10. Value Investing: Common Alternatives to Value Investing
  11. Value Investing: Conclusion

A company's income statement basically tells you how much money it has taken in and how much it has paid out over a year or a quarter. Looking at the annual income statement rather than a quarterly statement will give you a better idea of the company's overall position since many companies experience fluctuations in sales volume over the course of the year.

The first item on the income statement tells you how much money the company received from selling its products and/or services to its customers. This figure may be labeled "revenues," "net sales," "net operating revenues" or something similar. By comparing the current year's figure to previous years' figures, you can see if the company's sales are improving over time. Increasing sales also indicate that the company is growing. Amazon reported net sales of $24,509 million in 2009, for example, and this represented a significant increase over the $19,166 million it reported in 2008 and the $14,835 million it reported in 2007. (Though Amazon would be considered a growth stock, not a value stock, we're using it as an example here because everyone is familiar with the company and its financial statements are easy to read.)

Next, the income statement gets into the company's expenses. This second line might be called "cost of products sold," "cost of goods sold," "cost of sales," "cost of services" or some variation thereof. Subtracting the cost of revenue from the actual revenue generated produces the gross profit. In other words, how much revenue does the company actually earn after subtracting the cost to produce what it sells? Amazon reported cost of revenue at $18,978 for 2009. (All the numbers on the income statement are in millions, but the numbers are rounded and zeroes are dropped to keep things simple.) Subtracting this figure from $24,509 yields a gross profit of $5,531 million.

There are more expenses to account for, however, and gross profits must be high enough to cover them and leave a net profit. Companies have selling, general and administrative expenses (SG&A). Sometimes companies call these "selling, marketing and administrative expenses," or they might break the category down and list marketing expenses separately from general and administrative expenses. Some companies, like biotech companies, have research and development expenses in addition to SG&A. Amortization and depreciation are also considered operating expenses. Look at the company's expenses over time. If expenses are increasing, that isn't necessarily a bad thing if revenues are also increasing at a higher rate. However, you don't want to see expenses increasing over time as a percentage of revenues – you want to see them holding steady or decreasing as a percentage of revenues.

Subtracting total operating expenses from gross profit gives you the company's operating income. Amazon's total operating expenses for 2009 were $4,402 and included fulfillment, marketing, technology and content, general and administrative, and other. Subtracting $4,402 in operating expenses from $5,531 in gross profits left Amazon with $1,129 million in operating income.

After subtracting interest expenses and income taxes from operating income in addition to making any other company-specific adjustments, you get the company's net income, also called net earnings. This number is the "bottom line." For 2009, Amazon's net income or bottom line was $902 million.

Finally, the last lines of the income statement present the company's basic earnings per share and diluted earnings per share. Basic EPS divides net income by number of shares outstanding. Some companies describe shares outstanding as "basic average shares outstanding" or "shares used in calculation of earnings per share." Amazon's weighted average shares outstanding through 2009 amounted to 433 million. If we divide $902 million of earnings by 433 million shares outstanding, we get basic earnings per share of $2.08. Thankfully, we don't actually have to do the math because most companies do it for us in the financial reports. Analysts and investors are always looking for earnings per share growth.

The income statement also presents figures for diluted earnings per share. Most companies issue convertible securities such as stock options, convertible bonds, preferred stock and warrants. Diluted EPS represents earnings per share if all these financial instruments were converted to shares. If convertibles are turned into shares, there will be more total shares outstanding and each stockholder will own a smaller percentage of the company. Owning a smaller percentage of the company means owning a smaller percentage of the profits. Diluted EPS will thus be lower than basic EPS, but value investors want this difference to be small.

The income statement also shows how the number of shares outstanding has changed over time. Amazon's 2009 10-K, for example, shows that its basic shares were 423 million in 2008, 433 in 2009, and 447 in 2010. Although growth companies will typically increase the number of outstanding shares on a yearly basis, value stocks have a decreasing number of shares. When the number of shares decreases, reflecting share buyback programs, this activity is a good sign that indicates management's confidence in the company's future performance. It also means that each share of the company's stock is entitled to a higher percentage of earnings. On the other hand, if shares outstanding are increasing, it could mean that the company is handing out lots of stock options, which will dilute your earnings, or that the company is raising more money through stock offerings.

Calculating Profitability

Now that we understand what the numbers on the income statement mean, we can use them to calculate the most basic measures of profitability. Profit margin can be a more helpful indicator of a company's performance than net sales or net revenue because it takes costs into account. There are two types of profit margin: net and gross. Calculated as a percentage, net profit margin divides net profit by sales, while gross profit margin divides gross profit by sales. Remember, the numbers you need for these calculations are located at bottom and top of the income statement. For 2009, Amazon's gross profit margin was 5,531 / 24,509 = 22.57%; its net profit margin was $902 / 24,509 = 3.7%.

A low profit margin can indicate that a company's costs are too high or that the market won't support a high enough price for its products and services. However, there is not an absolute number that is considered a good profit margin; what is considered good depends on the industry the company belongs to. Comparing a company's profit margins to those of its competitors can provide some indication of whether the company has a good profit margin and how the company may perform long term. Comparing a company's most recent year's profit margin to its previous year's profit margins tells you how the company is performing over time. Value investors want to see a company's profit margin be higher than that of its competitors, and they want the companies they invest in to have consistent or increasing profit margins over time.

Remember, value investors are long-term investors, so it's important that when you look at a company's income statement, you see long-term profitability.

With all the information you have learned how to gather in this chapter and the previous chapter, you can now compare the stock you're interested in to others like it. Value investors find it especially helpful to compare stocks they're considering to those of similar companies that have recently been acquired. The price a stock sells for in an acquisition often accurately reflects the company's true value since acquisitions are transacted by well-informed investors. (These deals can make or break investors' returns. Find out how to tell the difference. See Analyzing An Acquisition Announcement.)

No matter how much research you do, though, value investing, like all types of investing, is not foolproof. In the next section, we'll discuss some of these risks and how to manage them.

Value Investing: Managing The Risks In Value Investing
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