How can traders evaluate a company’s performance? The answer isn’t as simple as deducting expenses from total revenue. There are a few measures of financial performance and profitability within an income statement, and each of these indicators tells a different story.
You’ll likely encounter some of these measures when reading a company’s earnings report or using the software available now at us.tradezero.co. Understanding these indicators helps traders assess a company’s performance over time, and how it compares with its competitors. Below, you’ll learn a few terms that should be a part of any investor’s stock trading vocabulary.
Net Income
It’s the simplest measure of a company’s profitability. Net income is the amount of money left after expenses-; such as administrative expenses, taxes, interest, and the cost of products sold-; are deducted from revenue. Depreciation and amortization are also subtracted. If expenses are higher than revenue, the total is considered a loss. The common term “bottom line” refers to a company’s net loss or income as it is shown in the income statement.
Earnings Before Interest and Taxes
Many analysts and investors use EBIT (earnings before interest and taxes) as a profitability indicator. EBIT is sometimes called operating profit. Because interest expenses and tax structures are different from one company to the next, setting these factors aside allows a trader to determine just how much a company is earning from daily operations. It also levels the playing field when comparing companies’ financial performance.
Earnings Before Interest, Taxes, Depreciation, and Amortization
Like the factor referenced above, EBITDA allows for an accurate, direct comparison between stocks and industries. Not only does EBITDA strip away taxes and interest, but it also removes amortization and depreciation.
Depreciation is a term used to explain how the cost of an asset is spread out over its lifespan; it allows a company to reduce its taxable earnings each year. For instance, if a piece of equipment is worth $1000 and is expected to last five years, the company can deduct $200 each year for depreciation.
Amortization is very similar, but it’s used to allocate the cost of an intangible asset. Stock traders may use EBITDA when evaluating companies with significant capital expenditures, such as utilities.
EPS or Earnings Per Share
EPS (earnings per share) is an indication of a company’s profitability per common stock share. Income statements typically include two earnings per share measure: diluted and basic. The basic EPS is calculated by dividing the company’s net income by its number of common shares.
If there are preferred shares, the dividends paid are deducted from net income before that total is divided by the number of common stock shares. If new shares were issued or bought back during any quarter, the weighted-average common share number would be used in the calculation of EPS.
A company’s diluted EPS is determined by dividing its net income by the number of common shares plus the number of shares that would be in play if convertible bonds, stock options, warrants, and preferred shares were exercised. Therefore, the company’s diluted EPS is usually lower than its basic EPS.
Considering EPS performance over an extended period will help investors assess the company’s profit trends if the number of outstanding shares remains relatively consistent. Keep in mind that companies can generate a higher EPS without adding net income if they buy back shares.
Price to Earnings
Beyond a company’s profitability, investors also want to compare the value of different companies’ stocks. The P/E or price to earnings ratio is the tool they use, and it’s determined by dividing the stock price by the EPS. This metric is great for comparative analysis, as looking at a single company’s P/E ratio without comparing it to another company’s figures won’t provide much new information.
Stocks with high P/E ratios trade at higher prices relative to their EPS. Those with lower P/E ratios trade at lower prices and could be considered inexpensive relative to other stocks with higher ratios. P/E is subjective, however. It’s typically used to compare companies within a sector because some newer sectors are known for higher ratios, while established industries’ ratios tend to be lower.
Return on Equity
Return on equity or ROE is an indicator that demonstrates the return on shareholder equity, and it’s just one way an investor can determine whether companies are spending their money wisely. ROE is given as a percentage that’s calculated by dividing the company’s net income by the value of its average common equity.
Investors can take the ROE and use it to compare companies to their peers. The ROE is different from an EPS calculation, as the denominator is the value of the average total equity rather than the number of outstanding shares.
Consider Your Rationale Before Investing in Stocks
Whether you’re a beginner or an experienced trader, it’s important to understand your reasons for buying a certain stock. What aspects of the company are compelling? It’s not a good idea to buy stocks based on the company’s brand, its employees, or long-held perceptions.
An investment based on emotions is the wrong investment to make. Likewise, a speculative investment may yield a profit, but it’s not wise to use them to form a long-term plan. For the most effective investment, focus on stocks that are priced fairly or undervalued.
Think about it for a minute. Even the biggest company in the world would be a bad investment if you paid too much for its stock. To make accurate comparisons and informed decisions, look to the fundamentals we’ve listed in this guide.
The Takeaway
The most crucial thing to remember is that, when you’re looking for a stock to buy, it’s vital to use multiple metrics to compare investments. Going by a single metric, such as the company’s net income, won’t give you the information needed to make the right decisions. An in-depth understanding of these terms, as well as an informed decision-making process, will do much to help you sell, buy, and hold stocks effectively.