Speaker 1: 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 statements 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, hire employees, rent buildings, et cetera, and ultimately the company's profit, which can be simplified as a company's 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, know 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 by 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 up 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% in 2020 and 33.3% 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 $750, their gross profit on that is $250. Calculated by taking the $750 sale price and subtracting out the cost of goods for that iPhone, $500. This is a gross margin of 33%. Calculated by taking the $250 gross profit and dividing it by the $750 sales price. However, if Apple is able to sell that same iPhone for $1,000 instead, the gross profit increases to $500. Calculated by taking the $1,000 sale price and subtracting out the $500 cost of sales. Then take that gross profit of $500 and divide it by the $1,000 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% 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 SG&A. 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&A 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, SG&A as a percentage of sales was 7% in 2019 and is 6% 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 a company is 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% 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 cashflow 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 20% 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 6% of sales for R&D and a decreasing SG&A over time. With SG&A as a percentage of sales at 5.75% in 2022, 5.5% in 2023, and 5.25% in 2024. I'm putting zero for other income and expenses since it's difficult to predict this amount because it isn't core to 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% 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.