One of the most important things to consider when investing in a stock is how profitable the company is after all is said and done. There are many measures of profitability, but net income is easily one of the most critical.
This figure is always found at the bottom of the income statement after all expenses have been deducted from revenue (the top line). Dividing net income by revenue yields a company's net margin for the period.
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Why net income is importantNet margins are important, because they tell investors how successful a company is at translating sales into profits. Ultimately, net income is the profit to which shareholders are entitled.
Dividing net income by the total number of outstanding shares gives you earnings per share. If you include all potentially dilutive securities such as warrants and employee stock options in the calculation, then you arrive at diluted earnings per share. This is the figure that investors and analysts typically focus on.
Some pitfalls of net incomeWhile net income is important, there are some pitfalls of the metric to consider. Because there are so many steps to get from revenue to net income, investors should understand some possible weaknesses of the metric and how it can potentially be manipulated by company management. There are many estimates that go into the various accounting constructs that make up an income statement (as you can see for Company TMF below).
For example, "depreciation and amortization" is considered an expense on the income statement that is deducted from revenue. But depreciating a long-lived asset, such as manufacturing equipment or a factory, entails significant estimates.
How much did the asset initially cost? How long will the asset be used? What will the residual value of the asset be when it is eventually retired? These are all questions that affect how much depreciation is recognized each period, which in turn affects net income.
There are other estimates all along the way from the top line to the bottom line, which is why cash flow metrics are useful to supplement net income. Additionally, recognized revenue does not always equal cash flow. That is especially true for any subscription business where companies must slowly recognize revenue over time.
Non-GAAP vs. GAAPAnother important distinction for investors to be aware of is the difference between GAAP and non-GAAP earnings. GAAP earnings are the official figures that abide by all required accounting rules.
But some companies do not believe that GAAP figures are the best representation of how the underlying business is performing. This is especially true in the tech sector, because companies often compensate employees with equity -- which is considered a non-cash expense -- and can have explosive revenue growth opportunities. On top of that, many software companies nowadays use subscription models.
Companies will often report non-GAAP earnings to supplement the required GAAP figures. Non-GAAP figures will exclude certain costs such as one-time items, or equity compensation, among other things. The drawback is that there is a lot of discretion when it comes to non-GAAP metrics, and each company can selectively choose what to include or not to include, which hurts comparability between companies even within the same sector.
The bottom lineAt the end of the day, investors should always look at a wide range of metrics to evaluate a stock. While net income and earnings per share are among the more important figures to keep an eye on, they do not paint a complete picture by themselves.
The article How to Find Net Income originally appeared on Fool.com.
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