Net Income why we care

During earnings season, there is a buzz and excitement in the stock market. This is the time companies report quarterly and year end revenue and net income. It’s a popular time for traders as there can be good trading opportunities due to the volatility in the stock price related to whether they meet, beat, or miss expectations.

Net income shows a company’s profits when total revenues exceed total expenses. You may also hear the terms income, earnings, or net profits referring to the same number. This is the income that is left over after all the expenses have been paid.

Basically, net income represents the profit of a company.

Therefore it is important for you to be familiar with the concept of net income.

End Users of Net Income

Companies need money for many reasons including:

  • Getting started
  • Expansions
  • Acquisitions
  • And simply operating

Not many companies can pay for all of these with cash from operations, so they need loans. The banks and creditors loaning money use the net income to assess the suitability of the loan. In particular, they will be interested in the cash flow from net income as an indication of the company’s ability to pay the loan.

Investors and shareholders use net income as a view of the overall profitability of the company. They will want to see if a company is profitable, how profitable, and whether the company can grow net income.

Management of a company will use net income as an indication of performance. They also look at the net income of competitors to get a view of their success, efficiency, and operations in comparison.

This can help management set performance benchmarks for their business segments. As well as provide insight to areas that may be lagging. A competitor may have expanded into a new market and management can make decisions on the potential of entering that market.

Why you should be familiar

There are many different products and services offered in many different industries and sectors throughout the global economy. In the end, companies are in the business of making money. In that sense, net income represents the success of the business.

While you can look at the revenue of a company and see how much money they bring in from sales. Net income will show the actual profitability of a company. A company can have a lot of sales but still have no net income.

This happens for many reasons. One such reason is with a new company in the early stages of growth. They may be spending more to market, create a brand, and grow than they are able to earn. This is normal for many new technology companies. However, if they never capture the income it will become hard to stay in business.

While a company is in the business of making money, so are you. You own shares in order to make a profit. When a company is operating at a loss, you will want to see a transition to profitability in some reasonable time frame or you might look elsewhere for an investment.

Looking at an earnings announcement can show the importance of income to the price of a stock. The days right around an earnings announcement are of particular interest to traders due to the volatility related to the announcement.

Examples:

Alphabet Company (GOOGL)

Report date: 4/29/2019 after market close

prior close 1296.20 – open 1190.63

google earnings gap chart

Image: thinkorswim

Abercrombie (ANF)

Report date: 03/06/2019 before market open- 1st oval– close 21.35 – open 24.16

Report date: 05/29/2019 before market open- 2nd oval— close 25.01 – open 19.66

abercrombie earnings gap chart

Image: thinkorswim

The grey ovals on the charts above show the gaps on the day after an earnings release. These moves tend to be larger than the average daily ranges due to the new information that is hitting the market.

The volatility on the days around earnings reports can provide many trading opportunities. Having an understanding of net income and other earnings-related numbers is important.

Where to find Net Income

It makes for a good habit to keep an eye on net income and there are a few easy places to look it up. The purpose of the income statement is to show the profit or loss of a company over a specified period of time. Therefore, the main place to find it is on the income statement.

Net income appears at the bottom of the income statement also referred to as the profit and loss statement. This is why many people call net income the “bottom line.” Net income then flows to the statement of cash flows. You can find it near the top of that statement where it is shown as a cash inflow.

income statement in excel

You can also find net income in company press releases when they report earnings. As well as many news outlets that send out the information as soon as it’s released.

Calculating Net Income

In its most basic form, net income is calculated by subtracting total expenses from total revenues. This will show you the profitability of the company.

net income formula

For a small business, that equation could very well be all there is to it. On the other hand, it will be a little more involved for a larger corporation.

There are many different expenses involved in operating a business. A large corporation may want to see these expenses broken out into different groups such as expenses related to operations versus expenses for the costs to make the goods they sell. (You can see this breakdown in the example of an income statement above)

By breaking expenses down in a more detailed way, you will have more information to use in analyzing the income. Instead of just total revenues and total expenses, you will see things like gross sales, net sales, operating expenses, cost of goods sold, and other expenses, etc.

In the end, all calculations result in the same number, net income. The “bottom line.”

How to Use Net Income

You will prefer to see high and/or rising net income. When it comes to buying stock in a company, earnings per share (EPS) and price to earnings (P/E) ratio are helpful in putting net income into perspective.

Earnings per share (EPS), also call net income per share, is important because it is the amount of money you would receive for each share of stock you own. That is, if all profits were distributed to shareholders.

Earnings per share is calculated by subtracting preferred dividends from net income and dividing by the weighted average common shares outstanding. The EPS formula looks like this:

EPS formula

EPS only measures the income available to common stockholders, therefore preferred dividends are taken out of net income. The weighted average common shares outstanding can be simplified by adding the beginning and ending outstanding shares and dividing by two.

A step further in relating net income to stock price would be to look at the price to earnings (P/E) ratio. The P/E ratio helps you analyze a company’s stock price based on its current earnings.

P/E ratio formula

The usefulness of the P/E ratio is in comparing like companies in the same industry. In general, a higher ratio means that investors anticipate higher performance and future growth. You can compare it to the industry averages and direct competitors to get a view of the perceived expectations of the company.

Final Thoughts

Net income is the profitability of a company and one of many metrics investors and traders look at when analyzing its potential.

In order to put it into perspective, you should look at it in a number of ways. You can look at the total amount, changes over the past year, and company guidance for the next year. In addition it is very helpful to look at the EPS number and P/E ratio for further insight.

You should be concerned with net income because you own a share of those earnings. The higher the net income, the more money you would receive from a dividend or potential appreciation in stock price. Earnings per share (EPS) being the amount of money earned for each share you own.

Looking at the price to earnings (P/E) ratio, you can put this into further perspective by comparing it to other companies in the same industry. A higher P/E ratio represents investors’ higher expectations for future earnings.

It is important to be aware of net income and how it affects a company’s share price. At the same time it is crucial to be aware of other metrics affecting a company or industry as a whole and use them all together.

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