Net income, also called the ‘bottom line,’ is what the company has left over after all expenses and taxes are accounted for. Think of net income as what you have left over from your paycheck after taxes are taken out, and after bills are paid.
When analyzing financial statements, I always find out what the CAGR (compound annual growth rate) is for the net income. This will tell me if, year over year, or quarter over quarter, if the company is increasing or decreasing their bottom line… on an average basis. If I look back, say, 5 years, and they have a CAGR of -2%, I will want to know why. If I look back that same time frame and the company has a CAGR of 30%, I will want to know if it is sustainable.
The “bottom line” of my example is this: a company’s net income can tell a big story. It is my job to investigate and find out what that story is.
Taxes are pretty straight forward for the most part and don’t fluctuate all that much. On the other hand, operating expenses are not necessarily straight forward, and can fluctuate quite drastically. For example: let’s assume company ABC one year has a net income of $1 million, but the following year, assuming revenue (sales) was the same, their net income was $750,000. Why is this if the revenue stayed the same? Well, I can tell you a few reasons why this might be.
- Maybe they had legal trouble. Companies are always getting sued for something. Maybe not all, but a lot. Usually the company can whether the storm, but if the lawsuit is big enough, they might be hurt badly from it. Legal woes can spell disaster for a company.
- Maybe they paid off some debt. All companies have debt, but what’s important is how much debt they have. If a company has taken on large sums of debt, they will want to pay it down as soon as possible. This is a positive thing for investors. A little debt is good, a lot of debt is bad.
- Maybe they bought new property (land, buildings, etc) to expand their business. This would be a good thing for value and growth investors, as it’s a sign they are heading in the right direction.
- Maybe they hired some big fancy CEO who they had to pay a lot of money to. This could be good or bad in an investors eyes. I would want to look into the new CEO’s history and find out how qualified they are for that position. Or, it could be bad from the simple standpoint that shareholders don’t want their company paying too much for upper management, regardless of who they are.
My point: it could mean a multitude of different things. In the scenario I gave, lower net income would be a red flag, and I would want to find out why they came in lower this year. This can only be accomplished by researching deeper into their financial statements.
Obviously a higher net income from the previous year would be a good sign. However, I would still want to find out why.
Let’s assume the same company had the same revenue as last year, but this year their bottom line shot up 25% to $1.25 million. I would want to know why that is, to see the direction that the company is moving. Some reasons for the increase…
- Maybe they cut their labor force. This could actually be a bad thing depending on why they cut their labor force; are they going out of business? Are they having troubles paying their bills?
- Maybe they sold some property they owned. This could also be a bad thing. Did they sell property because they are going out of business?
- Maybe they sold some investments they had. This, just like #1 and #2, could be a bad thing. Why did they need the cash? Or, maybe they just wanted to free up some room to invest in other assets.
Are you starting to see that one simple number at the bottom of an income statement can tell a very large story. That is the nature of fundamental analysis. Research is key. I have only named a few reasons for each scenario. Trust me, there are plenty more.
Now, my third and final scenario…
Let’s assume the same company increased revenue by 25%, and their bottom line also went up 25%. What could this mean? Well, it pretty much means they grew. This would be a good sign for me as an investor. It shows that this company is growing. However, there are still some questions you want to ask yourself.
- Is the growth sustainable, or did they get lucky? Some companies can have great growth for a quarter or two, or maybe even a year or two, then go right back down to where they were before. But that is not necessarily a bad thing to go back, as long as they were producing some kind of profit for their share holders. Steady companies are typically longer plays for investors.
- Did they cook their books? Yes, this happens. Accounting fraud happens. Even with the SEC (Securities and Exchange Commission) keeping tabs on it, it still happens.
As you can see, there are numerous scenarios within each scenario that I gave. The list goes on. Buying shares in a good company is not as easy as saying “Hey, their net income grew 25%. I’m gonna buy them right now!” No no… don’t do that. That would be a fantastic way to lose money over time.
Use net income as a piece to a much larger puzzle.