Investing
Financial Performance Metrics Every Investor Should Know
Evaluating a public company's financial performance can be complicated. There are several distinct performance measures within a company's income statement, each telling a different part of the story.
You'll likely come across these measures as you research stocks online or read a company's latest earnings report. Understanding them can help you determine how well a company is performing over time and how its valuation compares with industry peers.
Here are some financial terms that should be part of every stock investor's vocabulary:
- Net Income: Perhaps the most basic profit measure, net income is what remains 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. (See more on depreciation and amortization under EBITDA below.) If total expenses exceed revenue, this is called a net loss.
- Earnings Before Interest and Taxes (EBIT): EBIT is also known as operating profit. Because tax structures and interest expenses vary from company to company, setting interest and taxes aside lets you gauge how much a business is earning from its regular operations. EBIT is a helpful measure when comparing the financial performance of two or more companies.
- Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA): Like EBIT, EBITDA allows for more direct comparisons across companies and industries, this time by stripping out interest, taxes, 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, which allows companies to reduce their taxable earnings for multiple years. For example, say that a business owns a car that cost $40,000 and expects it to last for five years. The business might deduct $8,000 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. EBITDA can 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.
There are also several financial ratios that can prove helpful for valuing shares and comparing a company’s valuation to that of its peers:
- Earnings Per Share (EPS): EPS is the measure of a company's profitability per outstanding share of common stock. Common stock shares represent equity ownership in a company. You’ll 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 the company issued new shares or bought back any shares during the quarter, it would use the weighted-average number of common shares in the denominator.
For example, if a company has a net income of $100 million and has 50 million shares of common stock outstanding, the formula to determine EPS would be $100 million/50 million, which results in an EPS of $2.
A company might also issue preferred shares, a different class of stock that doesn’t typically confer voting rights but often yields higher dividends than common stock. If preferred shares are issued, the amount paid in dividends on these shares is subtracted from net income before dividing by the number of outstanding shares of common stock in the EPS calculation.
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 you determine how a company's profits are trending.
- Price to Earnings Ratio (P/E Ratio): A P/E ratio can help you compare the valuation of different stocks. It’s calculated by dividing the stock price by its EPS. A stock with a comparatively high P/E ratio trades at a higher price relative to its EPS than a stock with a lower P/E—in other words, it might be relatively expensive with respect to its earnings. A stock priced at $100 per share with $5 EPS has a P/E of 20.
P/E is generally used to compare companies in the same industry. Fast-growing companies tend to have higher P/E ratios, while firms in more mature, slow-growth industries tend to have lower P/Es.
- Return on Equity (ROE): ROE is a profitability measure that’s determined by dividing net income by common shareholder equity. For example, if a company has net income of $15 million and shareholder equity of $100 million, its ROE would be 15 percent. ROE is another ratio used to compare a company with its industry peers.
- Interest Coverage Ratio (ICR): The ICR is a way to measure how difficult it might be for a company to sustain its debt load. It’s calculated by dividing EBIT over annual interest expense, which is the amount a company pays in interest for money it borrows. A company with earnings of $60 million and interest expense of $20 million would have an ICR of 3. The lower the ratio, the lower the company’s ability to make its interest payments from earnings. Analysis of ICR might vary depending on the industry.
- Operating Margin: Operating margin is determined by dividing EBIT by total revenue and shows how much income is generated by each dollar of sales. It’s a way of comparing the profitability of different companies without having to adjust for differences in debt or tax rates. A company with $100 million of EBIT and revenue of $500 million would have an operating margin of 20 percent. As with most financial performance metrics, operating margin is best used when comparing a firm’s performance with its peers.
