## How Stock Fundamentals are Derived from Company Financials Part 2: Income Statement

In the first installment of this series, we looked at a company’s balance sheet to learn how to derive a number of useful fundamental ratios and metrics about the company. Since balance sheets are based on a reconciliation of the company’s assets and liabilities, the fundamentals that arise from this information give us a good idea of the company’s financial health. In part 2 of this series, we will examine the income statement, and determine how additional metrics such as the PE, PEG, market capitalization, and ROE are determined, among others.

This time around we’ll use the most recent annual report from Apple (AAPL) to go by, and we’ll use GuruFocus to compare our calculations with an online source. I use GuruFocus because it provides access to the past 10 years of financial data and supports nearly all of the ratios and metrics we’re interested in.

See also: Part I of this series: Balance Sheets

Apple’s fiscal year 2012 annual report was issued on October 31, 2012 and was based on the 12 months ended September 29. I would suggest that you download a copy of it so that you can follow along. The income statement can be found on page 43, and is called the Statement of Operations in this case. There will be a few situations where we need to pull some information from the other statements, but all of these are readily available in the same report. The following screenshot shows Apple’s 3rd quarter 2012 income statement (click to enlarge).

As mentioned above, we’ll be using GuruFocus’ numbers as a comparison to the ones we derive ourselves. A link to Apple’s fundamental data on GuruFocus can be found here.

## Market Capitalization

The size of a company is often measured by what’s called its Market Capitalization, which is a number which represents what it would cost to buy all of the company’s common stock right now at its current trading price. It is calculated by multiplying the total number of common shares outstanding by the current price per share as follows:

$text{Market Cap} = text{Current Stock Price x # Common Shares Outstanding}$

Since it’s based on the current price, market cap fluctuates throughout the day as the stock increases or decreases in value. As of today’s close, Apple was trading at a price of \$543.52. That’s our first input. We can pull the second number from the income statement. There are two numbers of shares listed on the statement – a diluted quantity and a basic quantity. Diluted takes into account possible future shares that may arise due to the exercise of stock options etc. while the basic number of shares represents the current picture. Since it’s the current market capitalization we’re after, the basic number of 934,818,000 common shares will be used in the calculation.

begin{align*}text{Market Cap} &= (543.52)(934,818,000) \ &= 507,793,137,600end{align*}

We arrive at a market capitalization of \$507.8 billion for Apple as of today. This can be compared to online sources and found to be correct. Most online stock websites don’t update market cap throughout the day, so the numbers may be a bit off from the calculation but should be close.

## EPS (Earnings per Share)

You may be wondering why I’ve included a section for EPS when it’s already clearly stated on the income statement. The potential source of confusion comes from the fact that there is more than one EPS value listed, both a basic and a diluted version. The reason for this is that the value calculated for EPS will vary depending on the number of shares used in the calculation. Since the diluted number of shares is always higher, a conservative approach is to use diluted EPS for most analysis. In this case, the diluted EPS was calculated as follows:

begin{align*}text{Diluted EPS} &= frac{text{Net Income}}{text{Diluted Common # Shares}} \

&= frac{41,733,000,000}{945,355,000} \

&= 44.15end{align*}

We can see that this agrees with the number stated on Apple’s income statement, and if we wanted the basic EPS we would just substitute the basic number of common outstanding shares in the equation.

Just as important as the company’s earnings however, is its earnings growth, and the income statement does not explicitly state what the growth rate is, either now or historically. More specifically, we are usually interested in what the compound growth rate has been over the past number of years. I’ve recently written another article on how to easily calculate compound annual growth rates in Microsoft Excel using historical stock data. Rather than have to dig up the past ten annual reports, GuruFocus makes the past 10 years of financials (including income statements) available to us online in a very convenient format. To access this information, click on the Financials tab as shown in the screen shot below. Using this data, I was able to determine that Apple’s EPS has been growing at a CAGR of 62% over the past 5 years.

## Revenue

Similar to EPS, revenue is reported directly on the income statement. Revenue is the total money brought in by the company in sales before the deduction of any expenses. It’s also useful to look at a company’s record of sales growth over time. Using the same CAGR calculation as above, we can easily determine how fast sales have grown over a period of time. I calculate that Apple’s revenue has grown at a compounded rate of 45% over the past 5 years.

## P/E Ratio (Price/Earnings)

A company’s P/E ratio is a popular method of gauging how expensive the stock is with respect to its earnings. I’ve previously written an in depth article previously outlining exactly what P/E is and how it’s used. The stock price used to calculate P/E is typically the current trading price, while the earnings portion of the calculation varies depending on the circumstances.

If for example we want to know the current P/E ratio then we typically use the EPS for the trailing 12 months (ttm). If we instead want to estimate what we think the P/E ratio will be in the future, we can use an estimate of future EPS – this is called the forward P/E. Let’s use today’s stock price of \$543.52 to calculate Apple’s current P/E ratio. We will use the diluted EPS value of \$44.15 from the income statement since there haven’t been any quarterly reports since the last annual report (in other words the EPS for the annual report is for the trailing 12 months).

begin{align*}text{P/E Ratio} &= frac{text{Stock Price}}{text{EPS (ttm)}} \

&= frac{543.52}{44.15} \

&= 12.3end{align*}

This agrees closely with the P/E ratio listed on GuruFocus.

## PEG ratio

PEG is an acronym for Price / Earnings to Growth, and is a popular metric for determining a stock’s potential value. It’s advantage over just a run of the mill P/E ratio, is that it also takes into account growth, or more specifically, earnings growth. This is important because high-growth companies typically have a higher P/E ratio, which would make them appear to be more expensive than a slow growing company. By including growth in the equation it serves to level the playing field so to speak.

We need two numbers to determine it. The first is the P/E ratio, which we’ve already determined above to be 12.3 currently. The second number we need is the estimated future EPS growth rate. The number used for this is typically the consensus, or average estimate from the pool of analysts that cover the stock. For Apple, the current consensus EPS growth rate estimate is 18.5% per year. We can now calculate PEG as follows:

begin{align*}text{PEG Ratio} &= frac{text{P/E Ratio}}{text{Future EPS Growth Rate}} \

&= frac{12.3}{0.185 * 100} \

&= 0.66end{align*}

Generally a PEG ratio of one is considered to be fairly valued. PEG’s less than one would indicate that the company is undervalued, and vice versa for a stock with a PEG > 1.

## P/S Ratio (Price/Sales)

The Price / Sales ratio is very similar to P/E except that revenue is used instead of earnings. P/S is used as yet another measure of company valuation, and is particularly useful in evaluating company that have no earnings, but still generate sales. It is most commonly calculated as follows:

$text{P/S Ratio} = frac{text{Stock Price}}{text{Revenue per Share (ttm)}}$

or

$text{P/S Ratio} = frac{text{Market Cap}}{text{Revenue (ttm)}}$

Since we’ve got a market cap of \$507.8 billion readily available (see above), we’ll use the 2nd equation. 2012 revenue can be found on Apple’s income statement as \$158,508,000,000 (beside the line item net sales). We can now calculate the P/S ratio:

begin{align*}text{P/S Ratio} &= frac{507,800,000,000}{158,508,000,000} \

&= 3.2end{align*}

## ROE (Return on Equity)

Return on Equity is a measure of the rate of return on the shareholder’s equity in the company. In other words its a measure of the profitability of the company as a percentage of the money shareholders have invested. Typically a ROE of greater than 15% is considered good. It is calculated as follows:

$ROE = frac{text{Net Income}}{text{Shareholder's Equity}}$

Net income can be pulled directly off the balance sheet. In 2012, Apple reported a net income of \$41,733 million. To get shareholder’s equity, we need to go back to the balance sheet, where we find it listed as \$118,210 million for 2012. We can now calculate ROE as follows:

begin{align*}ROE &= frac{41,733}{118,210} \

&= 0.353end{align*}

This mean’s that Apple’s ROE for last year was a little over 35%, which agrees with the number reported on GuruFocus.

## Other Profitability Measures

Sometimes also called management efficiency ratios, in addition to ROE there are other common ratios such as ROC (return on capital) and ROA (return on assets). Both are very similar to the ROE calculation in that Net Income is always used in the numerator.

Return on capital (ROC) for example, includes debt in the calculation to measure how efficiently returns are being generated on all of the capital that the company has in use – not just equity. The denominator is simply Total Capital, which in turn is the sum of shareholder’s equity and debt. Shareholder’s equity we know from above is \$118,210 million. Debt can also usually be found on the balance sheet, however in this case Apple has no debt so it’s not listed. ROC is therefore equal to ROE in Apple’s case (35%).

Return on assets (ROA) is similar once again, but uses the company’s total assets as the denominator. From Apple’s balance sheet, total assets as of year end 2012 were \$176,064 million, resulting in a ROA of 23.7%.

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## 4 thoughts on “How Stock Fundamentals are Derived from Company Financials Part 2: Income Statement”

1. I’m looking forward to Part III my favorite part of financial statements…. CASH FLOW!!!!!!!!!!!!!

2. […] Part II: How Stock Fundamentals are Derived from Company Financials: Income Statement […]

3. […] See also: Part II of this series: Income Statements […]