How can I do fundamental analysis of a stock?

Ever wondered how much money do companies like TCS, Infosys or Reliance bring in, how much money do they spend to operate and how much profits do they generate? In this article, I will explain how you, as an investor, can make use of an important financial statement called an income statement to get an insight into the company’s profitability.

I will touch upon all key parts that make up an income statement, what does it mean when financial experts talk about “top-line and bottom-line revenue” and help you understand the different types of profit margins.

Key parts of an income statement:

Let’s understand the key parts of an income statement with an example of Infosys. In the figure below, I used the income statement of Infosys (Ticker: INFY) for the years 2017–19.

(Source: Stock Share Price | Get Quote | BSE | INFY )

Let’s discuss FY2018 as all four quarter numbers are included in it.

Sales/Revenue: Sometimes referred to as “top-line”, revenue refers to how much money the company brought in by selling goods and services. As fig. indicates, In 2018 INFY had revenue of
₹ 6,19,410 million.
Other income: This measures how much money a company brought in for things other than selling goods and services. For instance, a company might sell a factory or win a legal settlement. As shown in fig INFY earned ₹40,190 million in other income in 2018.
Expenditure: It is classified into two categories COGS and SG&A. As shown in fig, in 2018, INFY had total expense worth ₹4,46,460 million

Cost of goods sold (COGS): This measures what a company must spend to actually create the good or service sold. These are direct costs, meaning they are costs for items that may literally go into the products. For instance, for a car manufacturing company, the cost of goods sold might include the cost of steel used to build the car.
Operating expenses (SG&A): These are indirect expenses, incurred by the companies as they conduct business, but may not go directly into the product. Operating expenses may include electricity bill, Employee salaries, marketing expenses, research, and development or administrative expenses.
Earnings before interest, taxes, depreciation and amortization (EBITDA): After deducting COGS and SG&A from Revenue we get EBITDA.EBITDA calculates earnings before any depreciation or amortization is determined. EBITDA is popular among highly leveraged and capital-intensive firms that require lots of depreciation calculations, such as utilities or telecommunications companies. This is because these firms have high depreciation rates and large interest payments on debt, often leaving them with negative earnings. In this figure, EBITDA hasn’t been shown but you will find it in 99% of income statements.
Interest expenses: Most companies borrow money (i.e. issue debt) to fund their operations or to buy inventory. These expenses measure the how much the company is paying to borrow money. As fig indicates, INFY has 0 interest payment because the company is debt free.
Earnings before interest and taxes (EBIT): This is what you are left with after you subtract COGS, operating expenses, and other expenses from revenue. Often referred to as EBIT.
PBDT: This is Earnings/Profit before Depreciation and tax. Here it is ₹2,15,260 million.
Depreciation: In accountancy, depreciation refers to two aspects of the same concept: The decrease in value of assets The allocation of the cost of assets to periods in which the assets are used Depreciation is a method of reallocating the cost of a tangible asset over its useful life span of it being in motion. (wiki)
As an example, a company acquires a machine that costs ₹60,000, and which has a useful life of five years. This means that it must depreciate the machine at the rate of ₹12,000 per year from P/L statement and Balance sheet (under PP&E).

As shown in fig, in 2018, INFY had total expense worth ₹14,080 million.
PBT: This is Earnings/Profit before tax. Here it is ₹1,99,080 million.
Taxes: This is a measure of taxes paid by the company. For companies that make a profit, taxes are an expense on the income statement.
Net income / PAT : After paying all costs and expenses, what’s left is the profit, or net income. This is a measure of how much the company earned during the period. As fig indicates, INFY had a net income of ₹1,61,550 million in 2018.

Taking in the Top Line: Revenue

Revenue is a critical item because it tells you how rapidly the company is growing (or shrinking), how strong demand is for company’s products and how a company ranks in size next to its rivals.

Keeping tabs on a company’s growth and margin.

As an investor, you always want to see revenue increase over time so the company’s earnings keep up with inflation. economy.

Digging into the company’s costs

A commonly used technique called common sizingcan be used toeasily see whether the company’s expenses are growing at an alarming pace compared with the growth of the business.

Tip: To perform common sizing, all you need to do is divide each cost and expense by total revenue and multiply by 100 to convert the number into a percentage.

In our case, in 2018, INFY’s all expenses accounted for
4,46,440 / 6,19,410 Mil. * 100 = 72% of total revenue.

Note: You can also perform year-over-year calculations as we did for the company’s revenue growth for 3, 5 or 10 years.

Tip: It is better to use several years of data while performing common-sizing so that you can identify a trend. For instance, if a company’s research and development budget is soaring, you’ll spot the trend.

What is the company’s bottom line or profit?

After paying all the bills, including all the direct costs, operating expenses and taxes, what’s left is the company’s net profit. It is sometimes referred to as a company’s “bottom line”. This tells you how a company did compared with the past and versus expectations investors had. As an investor, you will want to see how rapidly net income grew or shrunk compared with previous years.

Net income = Revenue — cost of goods sold — operating expenses+other income — other expenses — interest expense — taxes

Tip: Though net income is important, it should not be thought of as the end-all, be-all figure to focus on.

Types of Profit Margins

One of the best ways to measure a company’s profit is by studying profit margins. At its most basic level, a profit margin is how much a company has left after paying for its expenses.

Gross Profit Margin: A company’s gross profit, also called gross margin, is what’s left of revenue after subtracting direct costs, also known as cost of goods sold. It measures how much the company makes after paying costs directly connected with producing the product.
Operating Profit (OPM): Also called as operating margin, not only factors in a company’s direct costs but indirect costs, too. Operating profit is what’s left of revenue after subtracting overhead costs and cost of goods sold.
Net Profit Margin (NPM): A company’s net profit, net margin, or net income, is the most comprehensive measure of profitability and tells you how much money the company keeps after paying all its costs and expenses. At its simplest level, net profit is operating profit minus everything else.

Earnings Per Share (EPS): Most commonly known as EPS, it is calculated by dividing net income by the number of shares outstanding at the company. If net income tells you how large a pie is, EPS tells you how big your slice is.

You’ll always notice that two EPS calculations are performed on the income statement: one for basic EPS and the other for diluted EPS. The difference is in the way the number of shares outstanding is used.

Basic earnings per share: This measure tells you much of a slice of the company’s net profit you’re entitled to as a shareholder based on the number of shares that are outstanding right now. As fig indicates, INFY had a basic EPS of ₹71.28
Diluted earnings per share: Diluted EPS measures how much the company earned based on each share of stock that could be outstanding at some time in the future. It divides net income by the total number of shares that could possibly be outstanding, including the impact of employees converting their stock options into real shares.

Note: Diluted EPS is almost always less than basic EPS.

Tip: Using diluted shares is much more informative than using basic shares, because if and when securities such as stock options issued to employees and convertible bonds, are converted into shares of common stock, your stake in the company, or your piece of the total pie, gets smaller and smaller.

With the ability to analyze an income statement, you should get some sense as to how profitable a company actually is, a key consideration in deciding whether or not to become an investor in that company.

For complete Fundamental analysis you will also need to analyze: