Once more in “The Little Book of Value Investing,” author Christopher Browne took a plunge into the financial statements. In chapter 13, he continued to narrow his list of potential stocks by examining the income statement.
From the income statement, he wanted to determine the earnings potential or earnings power of a company. The full process began by finding a group of stocks available at bargain prices, identifying the reasons why those stocks were cheap and then assessing their financial strength with balance sheet analysis.
Extending that fundamental analysis to the income statement, Browne observed this financial statement is straightforward: How much money it took in and how much it paid out over a specified period such as a quarter or a year. He preferred to use annual statements because many stocks are affected by seasonal sales patterns.
The top line of the income statement provides the annual sales or revenue. He wrote, “These terms are interchangeable. In general, service companies have revenues, and manufacturing companies have sales. Revenues or sales are the lifeblood of the company.”
But the number by itself is not the full picture: Investors also must check sales or revenues over the past five or even 10 years. Is the company growing the size of its business or is it slipping? It’s also worth checking revenues by divisions, if possible, since the future of the core business may be hidden.
Next on the income statement come the expenses, including the cost of goods sold, which refers to the amount spent to bring in the revenue above. Costs include raw materials, labor and anything else directly connected to revenue. Analysis should include a historical perspective, to determine whether costs have risen disproportionately over the past five or 10 years.
Subtract the costs of goods sold from revenue to get the gross profit. When the percentage of gross profit is divided by revenue, the result is the gross profit margin. Browne considers a steadier gross profit margin better than a less-steady margin.
Getting back to the gross profit margin, the author subtracts selling, general and administrative expenses from it. These expenses are not tied directly to production or sales. Comprised of costs like maintaining headquarters operations, the lower this amount, the better. As Browne said, “A high or growing level of operating expenses could indicate bloated salaries or a less than watchful eye on overall expenses.”
After subtracting the operating or SG&A costs, you have the company’s operating profit, or earnings before interest and taxes (EBIT). Browne said this is the number he uses in valuations and the most important metric for someone who might buy the whole company.
Next, the final earnings are calculated by subtracting interest, taxes, depreciation (and presumably amortization, which is not listed here) from the operating profit. It is also called Ebitda, which is earnings before interest, taxes, depreciation and amortization.
Finally, Browne checked one-time gains or losses. These can distort earnings because they reflect something that happens only occasionally. Again, looking at a company’s history can help check for non-recurring items.
With that process completed and a final profit number, the company’s earnings per share can be calculated by dividing total earnings by the number of shares outstanding. Savvy analysts also check on the number of stock options that have been issued to executives and others and add those to the shares outstanding to come up with diluted earnings per share.
According to the author, the “most revealing aspect” of the income statement is historical perspective over the past five or 10 years:
- Are revenues growing or declining?
- Do expenses remain proportional to revenues?
- Are profits themselves consistent or quite variable?
- Are there any indications the company may be massaging its profit?
He also wants to know if the number of shares outstanding has been growing too much because that might indicate too many stock options are being granted. Alternatively, it may indicate the company is financing itself with stock offerings and not its earnings. Take it as a good sign if a company announces it will buy back shares—and executes the plan.
With earnings and earnings per share established, Browne liked to check return on capital, saying, “This is a good measure of how much money a company can earn on the capital it employs. A company with a high return on capital has a much greater chance of financing growth with self-generated cash than one with a low return.”
Rising ROC means management is doing an excellent job of reinvesting profits. Declining ROC suggests management is not reinvesting in the right places. For example, he cited the case of Philip Morris (now Altria Group MO) in the 1980s; at the time, it was one of the most profitable businesses in the country. However, its business of selling cigarettes was frowned upon and so its shares sold for just 9 times after-tax earnings.
Perhaps in a bid to improve its image, the company acquired a couple of major food companies. It bought General Foods at 15 times earnings and Kraft Foods (now Kraft Heinz KHC) for almost 20 times earnings. Browne asked, “Wouldn’t the shareholders of Philip Morris have been better off with the company buying in its own shares or paying out generous dividends?”
In addition to the gross profit margin, the author also liked to consider the net profit margins, calculated by dividing earnings by total revenues. He wrote, “If a company can grow its profit margins over time, every new dollar of goods sold has a leveraged impact on sales.”
Finally, he noted that while it may seem difficult to analyze an income statement when you first try, it doesn’t have to be:
“Once you have a basic understanding of what you are looking for in all the numbers, it becomes a relatively simple task to make the important calculations and comparisons. If you cannot understand a company’s income statement, just put that company in the no-thank-you pile instead of feeling that you are not smart enough to figure it out. A lot of reputedly smart professional analysts could not figure out Enron’s income statement, but that did not stop them from becoming big fans of the stock.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Christopher Browne: Tales That Are Told by the Balance Sheet
- Christopher Browne: Is This a Real Bargain Stock or Not?
- Christopher Browne: How to Find Value Opportunities
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