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This article is one part out of a four part series teaching you how to read an income statement. Click here to view the introduction or scroll to the bottom of this page to select another part.Revenue
A company’s revenues indicate how much money a company makes from their sales, not including any expenses or deductions. Revenue is commonly referred to as the “top line” since it is the first line of information on an income statement. Revenue is also commonly referred to as “sales” in the real world, but in the financial world, the word “revenue” is more commonly used.
Some companies have more than one revenue stream or at least decide to record more than one revenue stream. If you were to read RIM’s income statement in its annual report, where it goes significantly into more detail, you will find that the company splits its revenues into two categories: “Devices and other” and “Services and software”.
An Example
To help you understand all this revenue stuff, let’s use an example for our example.
If we look at your life from a business perspective we can say the following:
Your lucrative job as a potato peeler earns you $4,120 a year and your rich Great Uncle Angus gives you $880 for mowing his lawn, meaning you have two streams of revenue: revenue from daily operations and lawn mowing revenue- totalling $5,000.
How you managed to make an exact amount of money that totals a round number is beyond me, but you have – and now we see that your total revenue is $5,000. Now, you have to remember that this is the money that you make before any expenses such as income taxes, potato peeling tools or car payments…it is very likely that you will have significantly less than that $5,000 to put in your pocket by the time all the bills are paid.
Determining a Company’s Size
One of the best ways to determine the size of a company is by looking at how much revenue it generates.
Although, a lot of investors gauge the size of a company by its “Market Capitalization”, which is simply the amount of shares that a company has available to be bought multiplied by the company’s current price per share.
Whenever you search for a stock on MoneyCentral or Yahoo! Finance, one of the first pieces of information that will be given to you is the Market Capitalization – so do not work up a stroke by worrying about calculating all these numbers yourself.
A “Small-cap” stock is one with a market capitalization of under $2 billion. A “Mid-cap” stock’s market capitalization is between $2 billion and $10 billion and “Large-cap” stocks have a market capitalization of over $10 billion. Research in Motion has a market capitalization of $32.77 billion (as of November 4, 2009), meaning it is a Large-cap.
The biggest problem with determining the size of a company by market-cap is when a stock’s price plummets to the level of other tiny companies with tiny market capitalizations and tiny revenues – and now, once large-cap stocks are now on the same level as other small-cap stocks.
For instance, GM’s stock’s price per share fell from over $40 a few years ago to $0.60 today (ouch!) with its market capitalization falling from many billions to just under $400 million (small market capitalization)…yet GM’s revenues are higher than 99% of all other companies – at $150 billion.
So, if you use market capitalization to determine the size of a company, then you are ultimately saying that GM (with revenues of $150 billion) is the same as China Fire and Security Group (with revenues of $70 million).
That’s the same thing as saying that Paris Hilton’s cleavage is of the same calibre as Megan Fox’s just because they are around the same age – which I would have to say is clearly not the case. I would go into a full in-depth report about this subject, but unfortunately this site is dedicated to money and not celebrity cleavage.
Although, I’m not saying completely disregard looking at a company’s market capitalization, since it can be extremely useful to determine a stock’s health. For instance, by seeing that GM’s market-cap is on the same level as tiny stocks despite its massive revenue, you can quickly realize that the stock’s price dropped severely and thus there is something horribly wrong with this company – all done without analyzing a single chart.
On the other hand, if you see that a tiny company with tiny revenues has a market capitalization on par with huge companies, you can determine that the stock’s price skyrocketed recently and there is a good chance that it is extremely overvalued – and can drop in price drastically.
Analyzing Revenue Growth
I like stocks with massive growth. Why? Because they make me rich. It’s quite simple. And how do you know how fast a company is growing? You start by looking at its revenue.
Research in Motion’s revenue for 2009 was $11,065.19 million in 2009 and 6,009.4 million in 2008. To calculate the year over year growth, take the 2009 value and divide it by the 2008 value, subtract 1, multiply by 100 and slap a percentage sign to that number – giving you a growth rate of 84% for 2009. Do the same thing for 2008/2007, 2007/2006 and 2006/2005.
By the way, calculating all these numbers at first may be as annoying as scraping ice off of your windshield in the middle of a snow storm, but after a few times you get the hang of it and can calculate all these numbers without a second’s thought.
Anyway, after calculating the growth rate for the years we get the following year over year growth rates:
2009: 84%
2008: 98%
2007: 47%
2006: 53%
These numbers probably don’t mean much to you on their lonesome, especially if you don’t have much experience valuating stocks but then again, that’s what I’m here for – to make life make sense!
When a company is growing its revenues at 15% year over year, it is considered a “High Growth” company. In which case, RIM must be a “Super Explosive Congenially Metamorphosising Ball of Flame” company.
In the most ideal of scenarios, you would see that a stock’s revenue growth is increasing every year or is at least remaining consistent. In RIM’s case, the 6% fall in revenue growth from 2006 to 2007 isn’t much to worry about, especially since revenue doubled the next year. I wouldn’t even say the 14% fall in revenue growth from 2008 to 2009 is a big deal, since we were in the midst of the “the worst economic climate since the Great Depression” – so even maintaining a positive growth rate is a feat all by itself.
Then again, during this time, Research in Motion’s stock price plummeted from a high of around $150 down to around $35 at which point in time I swooped in and gobbled up all I could get of this stock – currently RIM is trading at almost $60.
This was just another case of investors being stupidly irrational as usual – does revenue growth slowing down by 14% to an already ridiculously high growth rate of 84% really constitute an 80% drop in stock price?
Even though RIM was the fastest growing company in 2008 (according to Fortune magazine), moron investors drove the stock price down further than they drove down companies whose earnings DECREASED from year over year. At least, thanks to idiot investors, I am given such wonderful and delightfully easy opportunities to make so many bags of money– and now I have just taught you how you can do the same. Congratulations!
When revenue growth drastically slows down or even decreases from year to year is when you have cause to panic. Find out why it happened – if it’s as a result of an economic slowdown (such as the 2008 recession) then you shouldn’t have much reason to start finding buyers for your organs, but if the economy is doing well then you should investigate the cause immediately. Read the company’s annual report or quarterly reports and any and all news you can find about the company to determine the culprit.
Cost of Revenue
The cost of revenue is exactly what the name indicates – the cost associated with producing the goods and services that make you that revenue. This can include raw materials, labour, energy and inventory. Cost of revenue is also sometimes referred to as “Cost of Goods Sold”.
Exemplifying
Let’s use another example to help you understand how the cost of revenue works by expanding on your potato peeling job scenario: Earlier, we said that you make $4,120 from your job before a single deduction is made.
Now, in order to peel enough potatoes in order to make that sum of $4,120, you have to buy a certain amount of buckets for waste storage, carving utensils, a stool and a few air fresheners. You calculate all those costs that were necessary in order to produce that revenue and you find that your expenses associated with producing those sales were $1,120. That means that your cost of revenue was $1,120.
It’s that simple.
Analyzing Cost of Revenue
The most important thing that you have to watch out for when analyzing a company’s income statement is to make sure that the growth of the cost of revenue does not exceed the growth of the revenue by a considerably high margin. If that is the case then something is horribly wrong, but if it’s just a few percentage points higher then there is nothing to worry about.
In an ideal and logical scenario, the costs associated with producing the revenue (cost of revenue) will rise hand-in-hand with the revenue. So, if revenue rises one year by 20%, ideally the cost of revenue would rise by 20% as well. This indicates that the costs are being managed well by the company.
There are also times that the cost of revenue or at least its growth will decrease while revenue growth increases – this is usually due to management being clever and cutting down on expenses that are associated with revenue, such as using cheaper materials to construct their products or by firing half of the work force. Always do research to find out why this change happened, since if half of the work force was cut that might be good news in terms of costs being cut in the short term, but for the future – it may be somewhat difficult to run a company with no employees.
Let’s take another look at Research in Motion and analyze its cost of revenue (ignore the Gross Profit portion for now):
We will calculate cost of revenue growth exactly the same as we did revenue growth…if you have recently suffered from a near-fatal blow to the head and lost most of your short-term memory – simply take the Cost of Revenue for 2009, divide it by the 2008 value, subtract 1, multiply by 100 and slap on a percentage sign to that number – now do the same for every other year!
Here is what we get:
2009: 104% versus 84% revenue growth
2008: 112% versus 98% revenue growth
2007: 49% versus 47% revenue growth
2006: 45% versus 53% revenue growth
Note: Instead of calculating two different sets of numbers and having your brain melt from the pressure of all these jumbles of numbers, you can simply make the Cost of Revenue as a percentage of revenue by dividing one year’s Cost of Revenue value into the same year’s revenue value and multiply by 100 to have a percentage and do the same with all years – this way you have to calculate half as much and you have half the numbers to struggle with yet all the information remains the same. This probably sounds extremely confusing right now, but keep reading and I will show you what I mean (Look out for Gross Profit Margin).
As you can see, the only time that cost of revenue grows significantly faster than actual revenue was in 2009, during the so-called horrible recession. Considering that costs for everything typically rise during tough economic times, we will let 2009’s disappointment slide. Otherwise, we can see that cost of revenue growth more-or-less directly kept pace with revenue growth, minus a small hitch or two – so there is no reason to throw out your Blackberry just yet.
Gross Profit
You get gross profit by subtracting the cost of revenue from revenue. This is your profit before factoring any operating expenses, taxes or interest. The importance of this number is to understand how efficiently management uses labour and supplies in the production process.
On its lonesome, the gross profit value doesn’t mean much – but when you twist this number just a bit then the value it brings is quite astounding. In fact, within this number’s power lies the ability to cure world hunger ten times over and bring peace to the Middle East. It can even help you accomplish the impossible task of assembling a desk from IKEA. Yes, that is how powerful this number can be.
I’m talking, of course, about calculating the Gross Profit Margin. Granted, I may have slightly over-exaggerated the importance of this number, but it is still quite important so please put down your pitchforks.
The importance of this number is that it gives you a very clear picture of how the company manages its production costs in relation to a base number (revenue). The higher the gross margin, the better the company manages its production costs. If the gross margin is extremely low then it means that the company is poorly managing production costs.
You can find the Gross Profit Margin by taking your gross profit and dividing it by revenue.
Looking back at RIM’s income statement, we see that the gross profit for 2009 was $5,097.3 million and revenue was $11,065.19 million. So, to find the gross profit margin we simply take the gross profit and divide it by the revenue to get 0.46, or we can multiply it by 100 and slap a percentage sign on to the end to get 46%.
When we calculate the gross profit margin for every year we get:
2009: 46% of revenue
2008: 51%
2007: 55%
2006: 55%
2005: 53%
We can see that Research in Motion has been pretty consistent with managing their costs, their gross profit staying around half of the total revenue. Unlike with cost of revenue though, it would be nice to see the gross profit margin rising – which would mean that the company is being more efficient with its costs and is thus raking in more cash.
When the gross profit margin begins to fall is when we begin to have problems. As I said earlier, don’t worry too much about results in tough economic times since costs are always higher, but when a company is performing worse in good economic times is when you should start getting suspicious.
Another good thing about gross profit margin (and any other margin or number divided into revenue for that matter) is the fact that it is able to put things so nicely into perspective by using percentages and allows to be easily compared to other companies. I will compare Research in Motion with arguably its biggest competitor, Apple as an example for easier understanding:
As of late, RIM has a gross profit of over $5 billion with sales of $11 billion whereas Apple has a gross profit of over $13 billion with sales of almost $37 billion. Judging by these numbers you can tell that Apple makes more money off of more revenues than RIM, but it doesn’t really tell us much about profitability. If you look at the gross profit margin of both companies (46% for RIM versus 36% for Apple) you can see that RIM makes ten cents more for every dollar it takes in compared to Apple, despite Apple actually raking in more money.
The best use of the Gross Profit Margin
Although you can get a good feel for where a company is going by doing what I just showed you regarding gross profit margin above, you can’t possibly know just how efficiently the company is working without comparing it to others in the same industry.
It’s the same thing as timing a one-legged gimp run one mile in four hours one day and then timing him run the same mile in one hour the next year. Sure, the gimp is four times faster than a year ago, but he is still slower than everyone else. That’s essentially what we are doing right now with RIM if we don’t compare it to its competitors.
So, now we know what we have to do so let’s compare Research in Motion with its two closest competitors, Apple (symbol: AAPL) and Palm (symbol: PALM).
Just search their stock symbols in that little box on the top-right of the screen to access their income statements. Once you’ve done that, calculate both companies’ gross profit margins for the last few years and list them to get something like this:
Year: RIM / AAPL / PALM
2009: 46% / 36% / 22%
2008: 51% / 34% / 30%
2007: 55% / 34% / 37%
2006: 55% / 29% / 33%
2005: 53% / 29% / 31%
As you can see, Research in Motion seems to be dominating its competitors when it comes to efficiently handling its production expenses since they have the highest gross profit margin out of the three companies.
Of course, comparing RIM directly with Apple may not be the most effective approach, since Apple produces a greater variety of products than just phones so take these results as a general guideline. I’m not even going to start discussing Palm, since just looking at those pathetic numbers makes me want to drench myself in fish blood and jump into a shark tank.
Anyway, if we further study these numbers past looking only at the efficiency of managing production costs, we will find that Apple is becoming more and more efficient with its costs every year (judging by the rising gross profit margin year after year), even during tough economic times when RIM’s gross profit margin plunged (2008 and 2009).
Of course, we can always argue that it is harder to steadily maintain the most effective management of production costs when you have a high gross profit margin as Research in Motion’s, beating out Apple’s by a whole 10% in 2009 and even more in previous years.
Then again, Apple makes three times the revenue of Research in Motion so no matter how efficient RIM will be with managing its costs, Apple will always make a higher gross profit (assuming its gross profit margin remains the same).
And before you start thinking you are the next of kin to Einstein and determine that Apple stock should be bought over Research in Motion because it makes three times the sales, remember that those facts are most likely represented in the stock’s price.
The easiest way to compare this is by taking a look at market capitalization. As I said earlier, RIM’s market-cap is just under $33 billion whereas Apple’s is almost $175 billion (as of this writing).
So, you just said that Apple should be worth three times as much as Research in Motion because it makes three times the sales – yet we see that Apple currently costs over five times more.
Make of that what you want, but all I am going to say is that never, ever make your decision based on gross profit alone. A lot of the time, companies can have absolutely amazing gross profit margins and show signs of extraordinary production cost management, only to have it all depleted by operating costs and end up with a huge loss in the end.
If you currently find yourself with a dumbfound look on your face, drooling all over your faux-cashmere sweater, do not worry, you will understand what I am talking about very soon. For now, just remember what I said.
When you are comparing companies
Only compare companies that are in the same industry, and ideally, companies that do the exact same thing. For instance, if you are valuating Wal-Mart, you’re not going to want to compare it to a company that mines for coal since they have completely different streams of income and costs that are associated with whatever it is that they do.
It seems that I have no other choice but to use this horribly clichéd example, but, you want to compare apples to apples. Comparing Wal-Mart to a coal company is the same as comparing an apple to a chainsaw – you’re not going to get very far.
Preface: What you need to know
Part One: General income statement information
Part Two: Revenue, Cost of Revenue and Gross Profit
Part Three: Operating Expenses and Operating Income
Part Four: Net Income and everything else
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