Financials Demystified: Earnings and EPS (w/ Real-Life Examples)

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2:11All right, folks, welcome to Investing for Beginners podcast. Today's show is going to be a little educational. We're going to talk about earnings and earnings per share and other aspects of earnings and how you can analyze them. And we're going to use our friends at fiscal.ai to help us showcase how you can easily and quickly analyze the earnings of a company. So I guess with that, Andrew, maybe can we, let's, I guess, first dive into what are earnings and where can you find them? Yeah. If you're a beginner, this is something you should try to figure out pretty soon. you'll find that earnings reports come and go companies do it every quarter and it really can drive performance of the stock yes in the short term but also sometimes a quarter or two can signal what's going on underlying in the business and that's the game that wall street tries to play is our recent reports is that is that something is it telling us about what the future of the businesses or is it just a one-time blimp?

3:19So that is the thing. And earnings helps us get there because earnings is profit. Revenue comes in, costs go out, you have taxes that we all have to pay unless you're losing money. And at the end of it is earnings per share. And it is earnings per share that dividends come from. It is earnings per share that companies are taxed on. It is earnings per share that creates balance sheet growth. So these are accounting terms. It's different from cash flow and we've talked about cash flow and we will talk about cash flow in the future. But the earnings per share is still important because it's a nice round number.

4:11It's again, what their taxes are based off of. And it gives us a good picture of the overall health of a business. So it's a nice number to be able to see. Yes. Yes, it is. And structurally, if you look at the income statement, which is where you will find earnings and earnings per share is it's the bottom line of the income statement. The top line is the revenue and the bottom line is the income, earnings, net income. The terminology can be interchangeable. You will see different terms in different companies' income statements. So don't get confused, especially if you're newer to this. Don't get confused by, oh, it says net income and Dave and Andrew keep talking about these earnings things.

4:59What is that? It's the exact same thing. It's just a different terminology. And the basic gist is, as you move down from the revenue to get to the earnings or net income, you have different costs and expenses along the way that you reduce from the revenue along the way. And there's different sections of the income statement. There's the gross margin section. There's the operating income. There's the earnings before taxes section. There's the gobbledygook of other income and taxes and all those other fun things. And then there's the earnings section. And so as you move down the income statement, you will see all those expenses and costs removed from what was generated in the revenue and what's left over is the earnings.

5:47And so one thing to always keep in mind is that this is an accounting, Andrew mentioned this, and it's important to reiterate, this is an accounting term. This is not necessarily the money that goes into your checking account per se, but it is definitely something you need to understand and it's an accounting term. So that means that this does not necessarily indicate real money. It does, but it doesn't. So it's kind of an odd place to be, but it's important to understand that as you move down the income statement, all those different factors can impact the bottom line of a company. And it's very, very important to understand how all those things flow together to give you the earnings.

6:30Because the earnings, like Andrew said, is really what drives things like paying a dividend. What kind of tax rate the company is going to have? How much can they reinvest in the business? All those things are driven from the earnings of the business. And so it's very, very important. And our friend, Uncle Warren spent a lot of time looking at the earnings of a business. And he was very, very, this was an important part for him to understand the earnings of a business. So I guess if we're looking, if we're using a company like Google, for example, or Alphabet, we all know it as Google. Really it's Alphabet, but I'm going to use Google the rest of the show.

7:11So just so everybody's understanding that. If we look at the income statement for Google, like what kinds of sections will we see and what kinds of numbers will we see when we get to the bottom? Yeah, that's a great question. So I'm going to share my screen for people who are following us on YouTube. We have had the other financials demystified episodes where we talked about, this has all been leading up to earnings. So if you've been paying attention, good job. Like Dave said, you have gross profit, operating profit, and then the last piece, earnings, this ties it all together. So episode one, if you'll recall, revenues minus cost of sales or cost of goods gives us gross profit.

7:56And then from gross profit, you take out operating expenses, which can include SG &A, Selling General Administrative, R &D, and then there's other operating expenses in there as well. But that gets you your operating profit or your operating income. also known as EBIT or earnings before interest and taxes. That is, if you recall from the last episode, that's all the operations of the business, the core business before we start getting into the interest and taxes. It's the, I have an ice cream shop and these are the costs to run the ice cream shop without the, I have a business and I have to pay taxes and I have to borrow money and pay interest on the money and the stuff that kind of cleans up everything at the end.

8:47So that's where we are now with going from operating profit down to net income. So if you look at this one for Google, you look at operating profit and then there's income before provision for income taxes, the provision for income taxes, and then we have net income. Inside of non-operating income, because I have the enterprise account, the enterprise plan for fiscal, I can actually click on the little magnifying glass and it'll show exactly where in the actual income statement that this number comes from. So you can see they have other income and expense, which comes from, this is subtracted from the income from operations or the operating income.

9:37So it's a small number for the quarter. Even you compare it to the first half of the year for that company, it's small compared to operating profit. But things like interest expense most likely are in there. A company like Google who has billions of dollars not only in debt but also in securities or maybe cash instruments, they also have interest income in addition to their interest expense. So sometimes that stuff nets, which is that can contribute to the non operating income being smaller. The taxes, I think, is a pretty big one in the respect of as a percentage of operating income, it can be pretty big, especially for a more mature company.

10:26So if you look at Google, this is something that's cool about fiscal. They automatically calculate the effective tax rate for you at the bottom. You can see over the last four or five years, it's been 13%, 16%, 17%, 15%. So because Google operates not only just in the U.S., but internationally, they have a lower tax rate on some of those international revenues. So if you took a company like Martin Marietta, for example, they're almost 100 % U.S. revenues, if not 100%, their effective tax rate is going to be higher because it's that higher U.S. tax rate versus somebody like a Google who's getting a lot of revenues abroad and pays lower tax rate on that.

11:11The other thing that can affect tax rates is growth companies. They can write off previous losses. So if I'm starting a new business and we just IPO'd and maybe we lose money for three years in a row, we can take those monies that we lost and we can write that off on future profits. And there's a limit to it, and it depends on the state. if you're doing a state tax carryover or a federal tax carryover. There's all these different rules, but that's something that growth companies can do. And I actually remember early, early days, this is like an into the nuggets of the archives of Warren Buffett's, all the literature, you could stack up buildings full of literature about Warren Buffett.

12:02there was one company who he had mentioned finding great value in because they had these tax carry forwards that he felt was not being appreciated by Wall Street and was going to be real profits in the future for the company. So that's like a whole different ballgame because Dave and I are boring 10-year investors. But you can sometimes find catalysts like that. and all that stuff does matter. I would argue that the operating parts of the business, that kind of carries everything. If you have an 80-20 rule, you have a great business, you have a great business. All the other stuff just kind of needs to be tied up and taken care of.

12:48But that little stuff too can make a difference and if a company doesn't do it in a way where they're not doing their job with taxes and interests and things like that, then it can come back and bite shareholders. So you do want to, where on the one side you're looking at earnings and sometimes you're ignoring it because you're like, okay, I really care about the core of the business. On the other side, there are those other pieces that you do have to kind of dot your I's and cross your T's on that do make an impact and do play a big part. And there's several different examples I want to dive into.

13:25before letting you talk after going on this tirade. But that's kind of the idea behind net income and how that all plays in the income statement. Yeah, that's awesome. That's a great breakdown. And it also, I think, does a good job of illustrating the importance of taxes and understanding the tax situation of the company and why it is the way it is. Because you will certainly see, excuse me, you will certainly see when you're looking at different types of businesses, you'll see different tax rates. And a company that I follow pretty closely to Jack Henry generally has a pretty high tax rate compared to some of the more tech companies that are more, you know, Jack Henry mostly operates here in the United States, I think primarily in the United States.

14:12And so to your point, they have a much higher tax rate and that definitely impacts the earnings of a company. And so if you're comparing company to company, that's something to keep in mind is that the tax rates could be higher for one company versus another one. And that alone could drive why the earnings for a company might be higher or lower than the other one, even though maybe the revenues are the same and the margins look the same. And then you get to the bottom line, like, why is this so much different? I'm not going to lie. Running a small business has been stressful lately, swamped in paperwork, different state agencies, and got all these expenses to track and everything.

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17:41If Apple is making$50 billion in a year, I don't even know what that means, right? That's where earnings per share comes in because as shareholders, we each own a little piece of the business. And you can think of that business being split like a pie into a bunch of little slices. And how much your slice, however many shares you bought, your one share of stock, how much profit can be allocated or how much of that is yours, quote unquote, as a shareholder is that earnings per share number. So you will see that number change depending on how the company is diced up. And I think that's important to understand, especially if you're a beginner.

18:24It's not that a company with$3 earnings per share is smaller than a company with$30 earnings per share. It's just how they've decided to slice the pie. And so that's why some stocks trade at$90, some trade at$300. Again, it's not about the actual per share number, but you just remember that there are different slices. When you buy a share stock, you're buying a slice. So having earnings per share and calculating that over the years for a stock gives us an apples to apples comparison on how the stock is doing, how the business is doing for shareholders in a way that is a lot easier and frankly makes better headlines also, which is not why they, I don't think that's why they do it, but it does make for better and easier headlines when you know that earnings per share went from 550 to six versus 56 billion to 58 billion.

19:23What does that even mean? So I don't know. That's something about earnings per share that I think makes it helpful and useful. What other things about earnings per share or fill in the gaps of like, what else about earnings per share do you think makes it useful for the individual stock picker? I think the biggest thing to me is the comparison like you're talking about. But alongside that is looking at the direction of two things. So number one is looking at the direction of the earnings, so the gross number. So if we're looking at Alphabet, for example, and you see that the earnings have grown from 10 years ago from$19.4 billion to$115.6 billion-ish in the last 12 months.

20:20So you can see that the gross number is growing and growing quite quickly, which is awesome and when you compare that to the earnings per share you see that that also correspondingly is growing really fast but the other thing to look at which is kind of cool and this is something that i kind of picked up on a while ago excuse me is comparing the the shares outstanding to the earnings in other words you want if you see what's really powerful is if you see both of them trending in the same direction. Well, I'm sorry, the opposite direction. So you want to see the gross earnings growing while you also want to see the shares outstanding decreasing because that is kind of a double whammy for an investor because the company is growing its earnings.

21:10So the operations and the revenue and everything is growing the earnings, but the company is also increasing your piece of the pie, to go back to Andrew's analogy, by reducing the share count. So as they buy back shares, you see that the earnings per share also grows tangentially with the revenue increasing, or I'm sorry, the earnings increasing and the shares outstanding decreasing. And so if sometimes you'll see companies that they'll report that their earnings per share, for example, are growing. But then if you look at the gross number for the earnings, it's actually flat. It's not really growing that fast.

21:50Their earnings are maybe growing at 1 % or 2%. But because they're buying back 4 % or 5 % of shares, you see a big earnings increase. And so it's not necessarily a death knell or a bad thing. But it's something to keep in mind. Okay, the operations, the business is kind of flat or is not growing as quickly. But because the company maybe has a really great cash position or generates a lot of cash, they reduce the share count, which boosts the earnings per share. And so that's also something to keep in mind. Andrew's showing us dominoes here, and I think that's probably a pretty good example of what I'm talking about.

22:30Would that be correct, sir? Yeah, I hope so. I mean, do you see the difference? The net income is up four and a half versus earnings per share over seven and a half per year. So yeah, that's not necessarily a flat net income, so it's not a perfect example. But it's definitely in there. If you look at companies like AutoZone, O 'Reilly, some of those more cannibal ones, I don't know this for a fact, but I'm going to guess as we pull this up, you're going to see pretty good earnings per share growing because they buy back a lot of shares, but I think operationally wise, it's probably not as impressive as looking at something like Google.

23:12And there you go. So as we can see on here, over the last four or five years, it's fairly flat as far as the earnings go, but the earnings per share have grown very nicely. And that's because the company has bought back so many shares. And so it's not just enough to look at the EPS number. You also have to go, I guess, that extra step is what I would recommend. is go that extra step and look and see if the earnings itself is actually growing and what is the company doing with the shares outstanding are they reducing that amount which gives you a bigger slice of the pie or is it going the other direction where they're maybe that's flat and the earnings are growing you know it it kind of depends on where the company is in their capital cycle what they're trying to do so it's it is definitely something to keep in mind maybe we could touch on like dilution like what what that is and how that impacts us as investors a perfect segue good job thank you so so the here we just talked about how share buybacks can juice eps growth because of that shares outstanding going down dilution does the exact opposite it.

24:26So to take that same example, if net income is flat, but the company is diluting, in other words, they're issuing shares. So a lot of times these days with tech companies, you see that play out in stock-based compensation. So they're issuing all these stock options to employees, which sometimes they invest over several years, whatever it may be. And the effect of that, if the company doesn't buy back to offset the share-based compensation, then it's dilutive to shareholders. So the shares outstanding is going up, which means your slice of the pie is getting smaller. And so a lot of growth companies will have levels of dilution.

25:10And so whatever growth the business is having doesn't always go back to shareholders. because if the amount of dilution is the same as the growth of the business, that doesn't do anything for you as a shareholder. So you grew companies' net income by 20%, but if you also grew shares outstanding by 20%, it's the same earnings per share. And that's something you can visualize it really clearly with REITs or real estate investment trusts. A lot of them use dilution. And it's not a bad thing necessarily. It's just a tool. It's a tool or it's a lever that companies use. But it's one of those where you're trusting management even more when you're investing in companies that have this dilution happening.

26:06And it does put pressure on management to make sure that they are growing. If they don't grow past that level of dilution, then obviously earnings per share will go down. And in the logical and rational world, that means stockholders are not happy. So that's kind of the thing to understand. And in my mind, I think it doesn't get enough attention, but I'm a grumpy value investor. What do I know? I think we're both grumpy value investors. So that's a A good example of what Andrew was just talking about is kind of what has gone on and will continue to go on at MetUp. So the company recently reported earnings and Wall Street loved them.

26:55It was fantastic. Great revenue growth, margin expansion, earnings growing, all this stuff. The caveat to that is that if you look at the history of the companies, particularly the earnings, you will see that they have been fairly flat and maybe even grown a little bit. And I suspect it will grow even more because Mark Zuckerberg is doubling down on AI. And part of his strategy is to hire the best of the best. And to do that, he's going to have to pay these people a lot of money and MBA level salary type numbers for developers. And the majority of that is going to come in stock-based compensation because they may or may not have the cash to pay these people that amount of money.

27:48So they'll use shares of the company to do that. now they are generating a lot of money but one of the the hiccup that could happen with this company i'm not saying it's going to but it's something to definitely keep in mind if you're on the fence or if you are invested in the company and you're not sure what's going on is is is to track this number is look at the shares outstanding and see if that number continues to grow because if there's that you know they also tout that they're spending a lot of money to buy back shares, but really it goes back to what Andrew was saying. It's an attempt to offset the potential dilution that they're going to be offering to these employees to really double down on the AI.

28:31They're going to spend$100 billion in CapEx in the coming year, and that doesn't include these stock-based compensation grants that they're going to be giving to these new people. So that being said, they're going to spend a lot of money for this, and nobody knows what the ROI is going to be on that. But the point is, is that you will sometimes see Wall Street trumpet how awesome a company does earnings per share or revenue or all those things. And that's all great, but there's always, you know, there's always a catch, right? What's in it, you know, and there is no free lunch on, on Wall Street.

29:07And so what Zuckerberg is attempting to do is try to not manipulate, but he's trying to work around the system so that he still looks good in the public eye and he can still get his goals accomplished and put the company on the map as far as AI goes. Now, whether or not he can do that or not, I'm not sure. And I have no skin in the game, so I'm not betting one way or the other. But if you were analyzing this company, that would be something I would definitely keep an eye on as we go along over the next three, four quarters is see what that see what happens with that share count and how that impacts the earnings of meta and i suspect you will see numbers you probably won't like much it's a great point yeah definitely important to track and we are seeing the this time where that stuff's not being scrutinized super closely and we'll see how it plays out like you said there's always winners is always losers.

30:05So it'll be interesting to see how that plays out. Do you mind if I talk impairments? I do not. I was actually next on my list of things to suggest. Oh, wow. We are on the same wavelength today. Look at that. Well, we've been doing this for how many years? We could figure that out eventually, right? So I'm going to eat crow. This will be fun. Crocs, who I have been public about being bullish on, on the show before and have recommended InValue Spotlight. Today it's down 27%. And there are different reasons why. One that we can discuss that is very pertinent to this conversation is they had a big impairment.

30:50So I will pull up fiscal one more time for Crocs and kind of show, and I'll put it, let's put it in quarterly so you can see. it's it's it's more drastic it's more drastic looking at it from a quarter by quarter basis august is national wellness month but most health trends equal things like buying random gadgets and guessing at what actually works based on whatever's trendy at the time and i wanted to stop guessing at things like that and actually look at the data behind my body i've mentioned it before but lately i've been taking time in the gym much more seriously not just to build a bunch of aesthetic muscles, but to build a good, sustainable, long-term health plan for my future.