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Why Net Income is Important to Investors

Posted on Tuesday, January 8th, 2019 by MarketBeat Staff

Summary - Net income is an accounting measurement that strips away all relevant expenses from a company’s revenue to show how much profit is really left. It is a way for investors to look past revenue figures and get a sense of how much revenue a company is retaining (i.e. how much profit are they making). Since the ability of a company to make a profit will have an effect on their stock price, net income is a fundamental metric that investors must watch closely.

A public company will typically release their net income at scheduled times throughout the year as part of their earnings report. These reports include not only providing detailed financial statements to shareholders and analysts but also may include conference calls to explain the past quarter’s results and provide guidance on the expected performance in the future.

Analysts use the information from the earnings report, of which net income is just one component, to make their recommendations. These recommendations can influence stock prices significantly in the period immediately following an earnings report.

Introduction

Over time, a company’s stock price will follow their earnings. In other words, a company may be able to get by with less than stellar profits for a period of time, but eventually, investors and analysts will take notice and retreat from their stock. In the same way, companies that report consistently positive earnings will generally be rewarded as investors see their past performance as a reason to continue investing in them.

A fundamental measure of a company’s profitability is their net income. This article will define net income and show how it is calculated, how investors should use it when comparing two companies, and how net income is different when used in personal finance.

What is net income?

Net income is the measurement of whether or not a company is making money and, if so, how much profit they are retaining. Net income is referred to in common accounting language as a company’s “bottom line”. The primary reason for this is because a company’s net income is found at the bottom of their balance sheet. But it’s also a useful description because it’s showing all the profit that’s left over when and if all expenses had to be accounted for. In this way, net income is different from a company’s actual cash flow because it includes things such as depreciation, amortization and stock-based compensation which may not come off the company’s books immediately.

The net income calculation also takes into account known costs of a business such as the cost of goods sold (COGS), operating expenses, other gains and losses, other expenses, depreciation and amortization, interest expenses and taxes. It does not take into account money that is paid out to shareholders in the form of a dividend.

The calculation for net income is as follows:

Total Revenue – (COGS + operating expenses + [other gains and losses] + other expenses + depreciation + amortization + interest expenses + taxes)

Net income is found on three of a company’s financial statements: balance sheet, income statement, and cash flow statement.

Why do dividends not count against net income?

They can, but only if they are dividends on preferred shares. The nature of a common stock dividend payment is that it is not required. Dividend payments are a byproduct of net income. They are one option, among many, that a company may use to allocate its profits.

For example, a relatively young startup company may be growing quickly and generating significant profits. However, instead of issuing a dividend, they may choose to put the money that would have been used for dividends into operational improvements to enhance efficiency and create further growth. Contrast that with a blue-chip company that may choose to allocate a portion of their profits to pay a dividend. Both companies may be exceptional companies, but for different reasons, they are choosing to allocate their resources in different ways. The extent to which one option is seen as better than another is from the perspective of the investor and what their objective is for owning the stock.

It should be noted that once a company starts to issue dividends, they will typically make a strong effort to continue to issue them. If the company is having profitability or cash flow concerns they may reduce the amount of the announced dividend, but they will generally go to great lengths to ensure the dividend is paid. Preferred dividends are different in that they must be paid and therefore they do reduce net income. Preferred dividend payments are also used in the calculation for earnings per share (see below).

If a company does not issue a dividend, then their net income should be equal to the difference between their retained earnings from one quarter to another.

Why is net income important to investors?

Essentially, net income tells an investor if a company is profitable. When a company is able to retain more of their revenue, it means they will be more likely to pass along these profits to shareholders in the form of dividends or reinvest the money back into their business without having to take on debt. Both of these are positive signs that their stock may draw the interest of other investors and be set to go higher. It’s important, however, for investors to review net income in a historical context. Sometimes a positive net income number may be sharply lower than the number posted the previous quarter or at the previous quarter in the same period last year. This does not by itself mean the company is a risk, but it does mean that investors should exercise due diligence to determine as best they can the reason for the change in net income.

Net income is also important because it is the basis upon which companies make other calculations such as earnings per share (EPS), their net profit margin, and as the starting point for their cash flow statement.

  • For earnings per share, net income is used as part of the following calculation:

EPS = net income – preferred dividends/weighted average common shares

Notice that preferred dividends are deducted. If a company does not issue a dividend on their preferred stock, the equation would be simply:

EPS = net income/weighted average common shares

  • Net profit margin is used to compare a company’s level of profitability to previous quarters or with other companies of similar size within their sector. In its simplest form, it is a ratio of a company’s net income to its revenue. The calculation is:

Net Profit Margin = Net Income/Revenue

  • When used with a cash flow statement, a company’s net income is brought over from their income statement and used as the first line item on their cash flow statement. Cash flow differs from net income because net income accounts for non-cash expenses such as depreciation, amortization and stock-based compensation.

Comparing the net income of two companies

Here’s an example that illustrates how an investor might use the net income to determine whether to invest in one company over another.

 

Company A

Company B

Revenue

$40 billion

$66 billion

Gross Profit

$17 billion

$35 billion

Net Income

$7 billion

$6 billion

Net Income as % of Revenue

17.5%

9%

 

If an investor were to look at either company individually, they would be able to determine that they were both profitable in the most recent quarter. However, an investor would have to compare their net income to that of recent quarters to determine a trend. In this case, they might see that Company A’s net income is going down whereas Company B’s income may be going up or is stable. That may make Company B a more attractive investment even though its net income is less than Company A.

But assuming that both companies are relatively equal in the trend of their net income, Company A may be a better investment not only because it has a higher net income but because it has a higher net income as a percentage of revenue, meaning more of its revenue is going to its bottom line.

How reliable is net income?

Although, in theory, net income figures could be manipulated by companies (i.e. revenue could be overstated or expenses could be understated), doing so would violate SEC rules and constitute fraud. For that reason, investors and analysts can rely on the accuracy of the net income a company reports.

How net income is different in personal finance

In personal finance, the accounting concept of net income comes into play when individuals or couples prepare their taxes. For the purposes of tax preparation, net income is the amount of income after taxes and deductions for things such as pre-tax contributions to a 401(k) or child tax credits. However, the Form 1040 that is sent to the IRS does not include a line item for net income. There are lines for gross income, adjusted gross income, and taxable income. Net income is derived from those three. Here’s an example of how calculating net income works for an individual tax return.

The pretax income an individual makes during the year is their gross income. Their adjusted gross income (AGI), also referred to as their take-home pay, takes into account all the taxes and other pretax deductions they have made, such as contributions to a 401(k). Both gross income and adjusted gross income are shown on the W2 statement that a taxpayer receives from their employer. When preparing taxes, individuals and couples subtract any other deductions to which they are entitled (such as child tax credits, charitable contributions, mortgage interest, etc.) to come up with their taxable income.  This is what the IRS uses to calculate the amount an individual or couple will owe in taxes or will have refunded. The difference between taxable income and income tax owed is net income.

As an example, let’s say an individual earned $75,000 in gross income. This individual had $10,000 in deductions, making their taxable income $65,000. If their tax rate is 15%, then their income tax payment would be $9,750 ($65,000 x .15). Their net income would therefore be $65,000-9,750 = $55,250.

What should be obvious is that calculating net income in the context of personal finance is different than the way a business will calculate net income. This is because the net income that taxpayers report to the IRS does not show all the other fixed costs that a household may have. In this sense, a more apples to apples comparison of the way a business records net income on a balance sheet to an individual household would be a household budget. This budget would take into account how much “profit” a household takes in (i.e. how much are they able to save based on the amount of income – or revenue – they have coming in).

The final word on net income

Net income is one of the fundamental metrics that a company will use in determining whether or not to invest in a particular company. Net income strips away the actual and forecasted expenses of a company (with the exception of dividends) to provide a “bottom line” of how much profit is being retained by the company. Net income is shown at the bottom of a company’s balance sheet and is therefore commonly referred to as the “bottom line”. Other names for net income include net profit and net earnings. These names are used interchangeably.

Common stock dividend payments are not subtracted from a company’s net income; however preferred stock dividend payments are. This is because dividend payments from preferred stock are required to be paid, while common stock dividend payments are not.

Net income is used on three key financial documents that a company will provide as part of their earnings reports: the balance sheet, the income statement, and the cash flow document. In each document, net income plays a slightly different role in the analysis that investors make.

In addition to its use in those documents, net income is used in the calculation of a company’s earnings per share (EPS) and its net profit margin.

When comparing two companies, it is important to understand that net income reflects a company’s profit position at a given point in time. To understand their profit trend, net income must be compared over various quarters or even years.

Finally, it’s important to understand that the net income reported by a business is different than the net income individuals arrive at when filing their income taxes. A better comparison of profitability between a business and an individual household would be a budget that shows expenses that must be paid.

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