Role of Earnings in Investment decisions

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Income statement is the snapshot of a company’s operational performance for a particular period of time. It takes the company’s revenues and expenses and gives profits as output. Take a look at the income statement of Global Telesystems:

As on 31-3-00
Net Sales 6065.51
Operating Income 6265.63
Operating Profit 2116.57
Operating PBDT 1700.44
Operating Profit before Tax(PBT) 928.63
Non-Operating Income 1562.62
Extraordinary/Prior Period income -171.23
Tax 30.00
Profit after tax(PAT) 2290.02
Cash Profit 3061.82
Dividend-Equity 100.40

Let us take a look at the different components of a Income statement of Global Tele.

First item is Net sales. Net sales is simply the product of quantity sold by the company and the selling price per unit. This figure is net of excise duty to be paid on the goods sold.

Next comes operating expenses. These are the expenses incurred in producing the goods like labor, fuel, power etc. The difference between the net sales and the operating expenses is the operating profit, which is a commonly used statistic to judge the operational performance of the company.

Next comes Operating profit before Tax, which is nothing but operating profit less interest and depreciation. Non operating income is the income that is not earned in the normal course of business operations. For example, interest earned on any investments made etc. Extra ordinary income is non recurring income that is earned only once and there are not any chances of earning that income again like profit on sale of any asset etc.

Cash profit is PAT plus any all non cash charges, i.e., charges that don’t entail actual cash outflow but they are only notional charges like depreciation, writing off preliminary expenses etc.

Role of Earnings in Investment decisions

Once you have got an understanding of Income statement, you are ready to be your own analyst. Each quarter, companies release their earnings, and, for companies using the traditional calendar-year approach, the quarter ended on New Year’s Eve. Earnings season is a great time to re-evaluate your current holdings to make sure the companies you own are living up to your expectations. But before earnings are even announced, you might want to review why you made the investment in the first place.

Whenever you buy a stock, write down in three or four sentences why you are doing so. State your reasons as objectively as you can. You might want to list such items as revenue growth, sustainability of earnings or growth over time, increased market share, increased gross margins, price targets for the stock or any other reasons you have for making the investment. For example, you might write, “I am buying XYZ Corp. because I think earnings will grow at a rate of 20% per year and that the price/earnings multiple will increase from its current level of 16 to between 22 and 25.”

By writing down your assumptions and your goals, you’ll create a benchmark that can help you see over time how the company is performing. If you’ve never done this in the past, you might want to start now.

Now take a look at the earnings. The earnings per share (EPS) number is a good place to start. The EPS is the total net profit of the company divided by the number of shares of stock outstanding. But don’t just look at the actual EPS and compare it to the expected EPS. Pull out your calculator and crunch some numbers.

First of all, has the number of shares outstanding changed significantly? Has the company bought back a large chunk of its stock? If so, earnings may have improved on a per-share basis, but may have stayed flat or even declined in real terms. Next, you should be on the lookout for any one-time charges. You will want to remove the effect of the one-time charge, as it only creates noise and makes year-over-year comparisons more difficult. Any one-time charge or gain will be stated in per-share amounts as a footnote. Just subtract it from the EPS if it is a gain, or add it back if it is a loss. Once you have the EPS number exclusive of one-time items, you can compare it to the EPS from the same quarter last year to see how much growth has occurred. Compare the growth figure of your company to others in the same industry.

Once you have gotten a good feel for the EPS, it’s time to look at the actual numbers on the income statement. Here are some questions to ponder while you have your calculator in hand. What does the growth rate in sales look like? How was it last quarter? Are gross margin percentages better or worse than they have been historically? Are expenses increasing faster than sales?

Using your written benchmarks for the stock, create a couple of additional questions to help you compare the company’s results with your own stated assumptions.

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