When investors inspect a firm’s income statement, they confront a series of earnings definitions, each including or excluding various expenses. The structure of the income statement places revenue, or sales, at the top and net income at the bottom. In between are a series of subtractions composed of different expenses. Earnings before interest, taxes, dividends and amortization are often known collectively as "EBITDA," an intermediate stage on the path to net income. Investors use net income, not EBITDA, when they compare the published earnings per share among different companies.
The Income Statement
Every quarter and at year’s end, corporations release income statements that disclose the profitability of the firm for the reporting period. The statement begins with revenue, or sales, of the firm. The first subtractions, yielding EBITDA, are the operating expenses for cost of goods sold and selling and general and administrative expenses. After depreciation and amortization are subtracted, the net figure is the operating income of the firm. Nonoperating income, such as the sale of an asset, are added in, followed by the subtraction of interest and taxes, leaving the result -- net income, or earnings.
The net income, or earnings, of a firm are accumulated in the company's retained earnings account, a measure of the value of stockholders’ ownership, or equity, in the firm. The total earnings for the year divided by the number of outstanding shares of common stock is called the earnings per share, or EPS. Analysts divide EPS into the stock price to calculate the price/earnings ratio. You can interpret the P/E ratio as the amount of money you pay, in stock price, for each dollar of earnings. A stock’s P/E multiple can make the shares seem expensive or cheap relative to the stock of other firms in the same industry. A 1995 study in the "Financial Analysts Journal" by David N. Dreman and Michael A. Berry showed that low P/E stocks outperformed stocks with a high P/E ratio.
A firm uses EBITDA to indicate the amount of money it can spend at its own discretion before paying for necessities like interest and taxes. The accounting profession does not recognize EBITDA as compliant with generally accepted accounting principles. However, the term is valuable because it ignores historical items that affect current profitability. For example, depreciation is a multiple-year expensing of long-term assets like plants and machines that the company has purchased. The depreciation is a non-cash expense that cuts net income yet doesn’t really help investors understand whether the company is having a good earnings year.
Investors use earnings in the form of P/E ratios when deciding to buy or sell a stock. Value-oriented investors look for underpriced stocks that can be purchased as bargains. For example, if the median P/E ratio in the car industry is 18, values below this figure may indicate an underpriced stock. They might also mean an underperforming company; the investor must decide what the values mean. To help in that decision, the investor may look at EBITDA to see whether the firm has solid operations but is saddled with other costs that hold down earnings. Acquisition-minded firms perform this same analysis when selecting takeover targets.
- Financial Intelligence: A Manager's Guide to Knowing What the Numbers Really Mean; Karen Berman et al
- EBITDA; iMinds
- Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions; Joshua Rosenbaum et al
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