There are several ways to measure profitability and financial performance within a company's income statement, each telling a different part of the story. Understanding them will help you determine how well a company is performing over time, and how it stacks up against its peers. These six terms should be part of every stock investor's vocabulary:
1. Net income: Perhaps the simplest profit measure, this is the sum of money remaining when total expenses -- such as the cost of goods sold, general and administrative expenses, interest paid on debt, and taxes -- are subtracted from total sales, or revenue. You also subtract depreciation and amortization, which are non-cash expenses. If total expenses exceed revenue, the negative total is referred to as a net loss. You have probably heard of the term "bottom line." This refers to a company's net income/loss, as it appears at the bottom of the income statement
2. EBIT (earnings before interest and taxes): Many investors and analysts prefer to use EBIT and EBITDA (see below) as an indicator of profitability. EBIT is often also referred to as operating profit. Because tax structures and interest expenses vary from company to company, setting interest and taxes aside allows investors to gauge how much a business is earning from its regular operations. It also helps create a more level playing field when comparing the financial performance of two or more companies.
3. EBITDA (earnings before interest, taxes, depreciation and amortization): Like EBIT, EBITDA allows for more direct comparisons across companies and industries, this time by stripping out not just interest and taxes but, as the name indicates, also depreciation and amortization.
Depreciation is an accounting term for spreading out the cost of a tangible asset with a limited lifespan – such as a piece of equipment, machinery or technology – over the lifetime of that asset, thereby allowing companies to reduce their taxable earnings year after year. For example, a business owns a car that cost $1,000 and expects it to last for five years. The business might deduct $200 per year as a depreciation expense for the use of the car.
Amortization is similar, but is used for allocating the cost of intangible assets such as trademarks over time. Investors may find EBITDA to be a useful metric when looking at companies with large capital expenditures, such as businesses in the utilities sector, because they might have significant depreciation.
4. EPS (earnings per share): EPS is the measure of a company's profitability per outstanding share of common stock. You will often see two EPS measures at the bottom of an income statement – basic and diluted.
Basic EPS is computed by dividing a company's net income by the number of outstanding common shares. If a company has also issued preferred shares – a different class of stock that does not confer voting rights, but typically yields higher dividends than common stocks — then the amount paid in dividends on preferred stocks is subtracted from the net income first. That total is then divided by the number of outstanding shares of common stock. If the company issued new shares during the quarter, or bought back any shares, the company would use the weighted-average number of common shares in the denominator.
For example, if a company has a net income of $102 million, pays out $2 million in preferred dividends and has 50 million shares of common stock outstanding, the formula to determine EPS would be ($102 million – $2 million)/50 million, which results in an EPS of $2.
Diluted EPS is calculated by dividing net income by the common shares outstanding plus the potential number of shares that would be outstanding if such instruments as preferred shares, convertible bonds, stock options and warrants were exercised. For this reason, Diluted EPS is typically lower than the Basic EPS figure.
Looking at a company's EPS performance over time can help an investor determine how a company's profits are trending, if the shares outstanding remain fairly constant. Remember that a firm could generate higher EPS without any additional net income if it just repurchases shares.
5. P/E ratio (price-to-earnings ratio): Beyond profitability, investors are often interested in comparing the value of different companies' stocks, and a P/E ratio can help them do just that. It's determined by dividing the price of the stock by its earnings per share. This is a metric built for comparative analysis, as looking at one company's P/E ratio without comparing it to another company or industry benchmark will not tell you much.
A stock with a comparatively high P/E ratio trades at a higher price relative to its earnings per share – in other words, it might be relatively expensive with respect to its earnings. A stock with a low P/E ratio is trading at a low price relative to its EPS, and could be considered cheap relative to its peers with a higher P/E ratio.
But, P/E is all relative. It is generally used to compare companies in the same sectors, since some sectors — particularly those with new, fast-growing companies — are known for having higher P/E ratios, while more established industries tend to have lower ones.
6. Return on equity (ROE): Return on equity is a profitability measure that helps to show the return on the shareholders' equity, which is one way for investors to gauge whether a company is spending its money productively. Return on equity is expressed as a percentage derived from dividing a company's net income (as described above) by the value of average common equity. An investor could take that number and use it to help examine how that company stacks up against its industry peers.
Note: this is different from EPS calculations, as the denominator in this equation is the value of average total equity, not the number of shares.
In the end, a strong grasp of these six terms can go a long way in helping you make an informed decision on what stocks to buy, sell or hold.
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This article originally appeared on TheAlertInvestor.com.