Follow the long journey that a sale takes toward moving a stock price.

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When I started as a green broker wannabe at Shearson Lehman Brothers, I was told to read The Wall Street Journal from front to back each morning. I found that useless, because I didn’t know what was important and what was irrelevant; it seemed like the paper was just a bunch of mishmash. Eventually, though, I found the Journal to be a morning must-read. Two of the most important topics to study in finance are how profits are made and how they are valued in stocks.
 
Rather than taking the scattershot approach I did in my first few months in the industry, let’s follow the long journey that a sale takes toward moving a stock price. There are two questions to answer: How profitable each sale is or will be? And how much is that future profit worth today?

Profitability

Profit is a raw number that isn’t too useful unless you’re looking at the trend of the same company. What investors are most interested in is profitabil­ity — that is, how much profit a company earns on some form of capital, be it assets, equity or the current stock price.

Your job as an investor is to generate the most profit on your invested dollars. An executive’s job might be focused on generating a high return on equity. But if we want to measure profitability, we still need to measure how much profit a company has made or will make. There are different ways to measure profit, and, luckily, the income statement does most of the work for us.

The income statement starts with total sales for some chosen period, typically either a quarter or a year, and
systematically deducts costs all the way down to net income, which is the net profit after all probable and measurable costs are factored in. Some of those are cash costs and some are estimates of future costs.

Broadly speaking, the higher up a cost appears on an income statement, the more certain and measurable it is. As we go down the income statement, management estimates come into play and the less profit has to do with the actual cash the company has generated for shareholders.

Revenue

Revenue is the total sales, interest and dividends earned by the company during the accounting period. The company may or may not have cash in from these activities, but it will have earned them. Sales is simply the number of units sold multiplied by the average selling price, and net sales is the sales after returns, discounts and allowances are deducted.

Cost of Goods Sold (COGS)

The first major cost is the raw materials and labor expenses spent on each unit sold. Materials used to build up inventory aren’t included, nor are shipping costs. Think of COGS as what’s spent between the start and end of the production line.

Net sales minus COGS is gross profit. Gross profit divided by sales is the gross margin (or gross income) and is an essential measure of profitability. Products that can’t generate gross profits are either in the very early stages of development — think prototypes — or are on their way toobscurity because competition has made it impossible to charge a price above basic materials and labor costs. Gross profit goes up by either lowering the costs of the inputs or raising the selling price.

Sales and General Expenses (SG&A)

The next category of expenses is for costs associated with selling the products and keeping the operation running. SG&A includes shipping costs, commissions, rent, advertising, labor of others not directly making the product, paper clips and other indirect costs. The profit­ability measure after SG&A expense is deducted is operating profit or net income from continuing operations. Like gross margins, the operating margin is operating profit divided by net sales.

You may want to consider all forms of revenue instead of simply sales. In that case, you should use earnings before interest and taxes (EBIT) instead. If the firm’s revenues come only from sales and nothing from interest or dividends from other companies, operating income and EBIT are interchangeable. There are other variations such as earnings before tax, which includes interest.

It Can Get Fuzzy

A major principle of accounting is that costs must be deducted as soon as a sale is made, including likely future costs. Management doesn’t know how many widgets will need to be fixed under warranty, nor does it know exactly how much the company will pay to repair worn factory equipment. Instead, the accountant deducts money from sales to pay for future expenses and places it into what’s called a reserve account.

Reserve accounts are accounting creations. They have little to do with actual cash and much more to do with whether the accountant determines the shareholder is better or worse off than the prior accounting (“fiscal”) quarter or year.

One of the more complicated issues is how management should account for aging factories and other equipment that have finite lives. There are a variety of ways to account for finite assets. One method is to estimate a useful life for each asset and reduce its value proportionately each accounting period.

The reduction in value is called depreciation — ­or depletion if it’s a natural resource such as timber or an oilfield — and it’s charged against net income whether or not there’s a cash outlay. If you don’t care about those things, you might want to use earnings before interest, taxes, depletion and amortization (EBITDA). Amortization is the grad­ual reduction in value of other assets, typically financial ones.

Chief financial officers can — at least to some degree — smooth earnings by increasing forecasted expenses during fat times and reversing those charges in lean times. For example, a company might estimate warranty expenses to be higher than reality. If earnings are likely to come in lower than expected, the company can reverse those charges and boost reported earnings.


This practice, called cookie jar accounting, is against Securities and Exchange Commission regulations. But if the company can defend the timing of reversals, cookies can still be plucked from the jar to help make a quarter’s numbers or improve a financial ratio when it’s needed.

Taxes

The tax expense on the income statement isn’t the cash the company pays to the IRS and any other taxing authority. It’s an estimated tax expense. If cash taxes paid are less than the estimate, it might be a deferred tax and appear on the balance sheet as a deferred tax liability. Likewise, a tax-loss carryforward that can be applied against future tax liabilities will appear as a deferred tax asset.

You may notice additional costs or gains associated with unusual or extra-ordinary items. Analysts usually ignore those one-time events, because they don’t indicate much about the future earnings of the company. They prefer to focus on recurring revenues and costs because, as we’ll see shortly, they have a much bigger impact on the value of a stock. Once you’ve deducted all the costs associated with a period’s revenue, you have the company’s net income. The raw net income figure won’t be relevant until you divide it by the shares outstanding, which gives you net income per share. That’s the claim each share has on the company’s current earnings.

Show Me the Money

Net income per share is the most popular measure of profit on Wall Street. Firms can temp­orarily boost cash flow through slowing down regular maintenance or encouraging customers to pay earlier. But shareholders’ interests aren’t being served if the company has to replace poorly maintained equipment more often or earns less on selling its products than it should. Even with the challenges of estimating future costs, net income provides the most comprehensive measure of profitability, other than cracking the company’s books yourself.

Once a company earns a profit, it can use the profit to either reward shareholders directly by paying out a cash dividend, indirectly through buying back stock or reinvesting it back into the company. If the company is growing at a faster rate than most or a stronger balance sheet would reduce its borrowing costs or reduce the risk of bankruptcy, reinvesting cash internally would be the best option.

But even if the company is simply building up cash, it’s building wealth for shareholders. Shareholders own what’s left of the company after all debts and obligations are paid. If assets grow at a faster rate than liabilities, the company is worth that much more.

The relationship between stock buybacks and shareholder wealth isn’t as clear as a dividend, but it has become increasingly popular over the years. Dividends received are taxed as ordinary income. But share buybacks accomplish two things: They reduce the shares available for sale on the market, making other shareholders’ stakes more valuable — remember decreased supply and the same demand leads to higher prices —and it increases the ownership stake of shares that weren’t bought back by the com­pany. Picture a pizza
slice from a pie cut into four slices instead of a slice from a pie cut eight ways.

On to Valuation

Once we forecast the profit a company will make and choose a base (assets, equity or share price), we need to decide what determines whether the stock is underpriced or overpriced. The easiest way to do that is by comparing profitability of one company to others in the same industry, sector, index, size or any other grouping you choose.


The best ratio to use will be the one that helps you predict stock prices. That might seem circular, but other analysts often do that research for you. As you read through com­panies’ annual reports, press releases and analysts’ commentaries, you’ll begin to identify the measures that will be most valuable.

Each industry has its own preferred
set of metrics that, over time, have proven to be the most reliable leading indicators of stock performance. They won’t be perfectly accurate. Stocks can remain overpriced or underpriced for quite some time. That’s because not only do investors try to allocate their investment capital to the most profitable companies — or the ones whose profits are growing the fastest — but they also handicap their profitability forecasts by how confident they are that the forecast will be accurate.

Treasury bill investors accept very low interest rates because they’re quite confident the U.S. Treasury will honor its obligations. Similarly, micro-cap investors should logicallydemand higher potential returns than what they would from large-capstocks owing to the limited amount of information and reserach available on smaller companies.

Look at Profitability Several Ways

If a company has a gross margin fairly typical of its industry but has a much higher price-earnings ratio, you can evaluate other profitability measures to find out why the market values the company more than others. The market might be ignoring the price-earnings ratio in favor of other ratios. Another possibility is investors may be looking at the future of the company rather than what it may have done in the past.
     
Finding the data you want presented in a coherent way can be quite a challenge. One very useful (and free) starting point for “comps” can be found on the webpage of New York University’s finance professor Aswath Damodaran.

Damodaran is widely regarded as a guru of valuation within the investment industry and he shares many educational and intriguing tools and articles on his site. It may take time initially to find what you’re looking for, but learning what’s available there will be time well spent.
     
When it comes to analyzing profitability and putting price tags on it, practice counts. Keep notes on why you bought and sold each stock and occasionally look back on those notes
to see what you got right and what you may have gotten wrong.

Practice won’t make for perfection, though. There’s always going tobe at least some random noise in the market. Developing clear analyses and, above all, staying patient with them will help you stay confident that you have the right stocks and the market will eventually want what you already have.
 
 

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