How to Analyze an Income Statement Like a Hedge Fund Analyst

being able to understand and analyze a company's income statement is one of the most foundational pieces of being a great investor if you want to invest successfully this is one of the most important skills in helping you make money by investing in this video we're going to go over how to read and analyze a company's income statement using apple as an example this video will be helpful for you whether you are just starting out with investing or if you've been investing for years i'm going to draw upon my experience working at a large investment firm to help you better understand the material and more importantly how you can apply it to your own investing process now let's get into the video so before we jump into the explanation and the analysis let's first understand what exactly an income statement is and why companies have them an income statement is one of the three important financial statement used for reporting a company's financial performance over a specific period of time with the other two key statements being the balance sheet and the statement of cash flows the income statement breaks down a company's revenue the money they made from selling their products and services their expenses such as the cost to make the product higher employees rent buildings etc and ultimately the company's profit which can be simplified as a company sales minus all the expenses associated with running the business so now that we understand the high level theory behind the income statement let's make this more practical by using apple and their income statement as an example all publicly traded companies are required by the government to post their financial information online for the public to see it's super easy to pull up a company's financial statements just simply google search annual report and the name of the company's information you want to find so in this example we are going to search annual report apple this will bring us to apple's investor relations website on that website we just click on the link to their most recent annual report this will bring up apple's annual report otherwise referred to as their 10k within the annual report is apple's income statement now let's start breaking down and analyzing the income statement real quick just a couple of things to note as you're looking at a company's income statement first note how in the case of apple these numbers are in millions of dollars and this is just to make the income statement more condensed and easier to read so total sales in 2021 was 365 billion not 365 000 and then another important thing to note is that some companies don't have the years on their income statement match up with the calendar year so for example apple's 2021 year ended in september 2021 not december 2021 i have been analyzing companies for years and got a degree in accounting from college and i still don't understand why some companies do this it's not super important but just something to keep in mind now let's get into the details of the income statement at the top of any income statement the first and important line is the company sales companies will usually break down their sales into different segments or buy geographies this is because companies want to provide more detail around what makes up their sales so if you look at tesla for example you can see that they break down their revenue into automotive sales which is revenue from selling vehicles automotive leasing which is essentially renting the vehicles to customers over a relatively long period of time and then they have energy generation and storage this is where the company has its solar panel business then financial services and others if you look at apple on the other hand they break out the revenue into two separate categories products which is from the sale of physical products such as iphones ipads airpods apple watches and macs and then services which is revenue from software and subscription services so this would include app store revenue apple music cloud storage and anything else that isn't a physical product it's really important to understand why companies separate their revenue into these different categories when companies break down their revenue like this it helps you as an investor have a more detailed understanding of how the company is performing in the case of apple ceo tim cook and the management team has made it a priority in recent years to grow the services side of the business by apple breaking out the services revenue from the product revenue you can easily see how management is progressing against that goal by comparing the year-over-year growth of the services revenue to that of the products revenue you can see that the services revenue is growing faster now moving down to apple's combined revenue you as an investor usually want to see that revenue growing this is why it's helpful for you to see at what rate the company is growing its revenue and then compare that to its competitors in the same industry in the case of apple we can see that they grew revenue 5.5 percent in 2020 and 33.3 percent in 2021. moving down the income statement next we have cost of sales these are the costs associated with building the product or service you are selling so let's say you're general motors and you sell cars your cost of sales would be the cost of the tires the engine the frame of the vehicle the interior and pretty much everything else that goes into building the car so in the case of apple it would be the costs that go into manufacturing the iphone ipad mac and all of the other products and services the company sells when analyzing this part of the income statement an important thing to calculate and consider is what is referred to as gross margin let's show how this is calculated you take sales and subtract out cost of goods this leaves you with what is referred to as gross profit you then take that gross profit and divide that number by your sales this leaves you with the percentage the higher the gross margin generally speaking the better this is because having a high gross margin is representative of having strong pricing power let me explain what i mean let's say it costs apple 500 to produce an iphone if they are able to sell that phone for seven hundred and fifty dollars their gross profit on that is two hundred and fifty dollars calculated by taking the seven hundred and fifty dollar sale price and subtracting out the cost of goods for that iphone five 500 this is a gross margin of 33 percent calculated by taking the 250 dollar gross profit and dividing it by the 750 dollar sales price however if apple is able to sell that same iphone for one thousand dollars instead the gross profit increases to five hundred dollars calculated by taking the one thousand dollar sale price and subtracting out the five hundred dollar cost of sales then take that gross profit of five hundred dollars and divide it by the one thousand dollar sale price leaving you with a 50 gross margin now that we understand this concept something important to point out is the difference in gross margin between the product side of the business and the service side of the business the gross margin in the services business is almost double that of the products business now you can see why management really wanted to focus on growing the services side of the business and why it is important for apple to break out the services revenue from the products revenue as an investor you generally want to see gross margins getting larger over time this is the case with apple gross margins were 37.8 in 2019 38.2 in 2020 and 41.8 percent in 2021. continuing down the income statement next we have operating expenses these are the expenses associated with running the business whereas cost of goods sold or cost of sales are the expenses associated more directly with manufacturing the products and creating the services for apple the two main operating expense categories are research and development or r d for short and selling general and administrative expenses commonly referred to as sgna research and development as the name suggests are costs associated with researching and developing new products so in the case of apple an example of that would be the secret or not so secret apple car the company is working on all of the expenses associated with that would be classified as r d sg are things such as office rent employee wages marketing and pretty much any other costs associated with the business that aren't a part of cost of sales or r d when it comes to r d and sg a a great way to analyze these costs is to compare them to total revenue additionally as a company grows its sales you look to see if it is able to keep expenses the same or at least have them grow slower than sales so for example sgna as a percentage of sales was seven percent in 2019 and is six percent in 2021. generally speaking you want to see this trend downwards over time next we have operating profit which is essentially the company's profit before subtracting out taxes and interest paid on debt this is calculated by taking your revenue and subtracting out the total cost of sales as well as the total operating expenses an important tool here for analyzing accompanies the operating margin which is simply the operating profit divided by the revenue this is important because it shows how much of each dollar of revenue is turned into profit the higher this percentage the better and it's a great sign to see this trend upwards over time in the case of apple we can see that the operating margin was 24 in 2019 and nearly 30 percent in 2021. the next line item is other income and expenses these are income and expenses that fall out of the scope of the company's normal operations so if apple made an investment in a tech startup and that investment made the company money that would likely be included in this line then we have earnings before taxes which is exactly what it sounds like we then subtract out taxes to get a final net income figure this is the figure that most people think of when they are talking about a company's profit so now that we have an understanding of the basics of an income statement it's important to also have an understanding of how different growth and profitability related variables will affect the company's future results i created a basic financial model that lets me see how different growth rates gross margins and operating expenses will ultimately affect apple's profitability all of the numbers in blue are variables that i can change based upon my future expectations for how the company will perform these projections set the foundation for a discounted cash flow evaluation which is ultimately used to determine if a stock is undervalued if it would be helpful for you guys i can cover that in detail in a separate video just please let me know in the comments just to show you how this works let me walk through some hypothetical numbers let's say i assume that apple will be able to grow the products business by 10 and let's just say apple is able to grow the services side of the business by twenty percent a year moving down to gross margin i'm going to assume that apple is able to expand their gross margin by selling their products at higher prices i'm putting a 36 gross margin in 2022 37 in 2023 and 38 in 2024. for the services side i'm assuming 70 in 2022 71 in 2023 and 72 in 2024 moving down the spreadsheet i am assuming a constant six percent of sales for r d and a decreasing sg a over time with sg a as a percentage of sales at 5.75 percent in 2022 5.5 percent in 2023 and 5.25 percent in 2024 and putting zero for other income and expenses since it's difficult to predict this amount because it is in court of the business and then finally i'm assuming a 15 tax rate now let's see what these projections get us in terms of net income with these assumptions net income grows by 14.2 in 2022 18.3 in 2023 and 18.2 percent in 2024. again these are all just hypothetical numbers and don't represent what i think apple's financial performance will truly look like but i hope it demonstrates how to think about projections and analysis on the income statement so there we have it if you want full access to all of my spreadsheets and tools that i use to analyze stocks subscribe to my patreon which is where i upload all of these tools as always make sure to like this video and subscribe to the investor center let me know what your thoughts are of the video in the comments i look forward to hearing what you guys have to say talk to you again soon

Channel: Investor Center

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Keywords: how to analyze an income statement, income statements for beginners, how to analyze financial statements like a pro, how to analyze financial statements like a hedge fund analyst, how to analyze stocks, how to analyze the financial statements of a stock, how to analyze the financial statement of a company, investing for beginners, how to invest for beginners, how to analyze a company, how to analyze a stock for investing, investor center, swedish investor, bill ackman

Id: ht-tzwyLPUI

Length: 11min 24sec (684 seconds)

Published: Tue Dec 28 2021