Should I buy stock in Company X? - Part 2

Monday, June 30, 2008

In the previous post, Liz's finances were used because everyone can relate to having a job and receiving a paycheck on a regular basis. Let us take a moment to compare what we know about personal finances and apply it to the finances of a business.

We will use Kid's Toy Store finances as our business example. Liz has a salary of $24,000 per year as a manager of a bookstore. Last year, Kid's Toy Store sold $100,000 worth of toys. So, Liz's salary, or earnings, can be compared with last year's sales of toys at Kid's Toy Store. Sales are sometimes referred to as revenue, you can use either term. Just as Liz has bills, so does Kid's Toy Store which are called expenses or liabilities. Liz manages her finances on a monthly basis, however, a business usually reports (prepares financial figures for the public) on a quarterly basis.

Most business work on fiscal calender split into 4 quarters; 1st Quarter is from January to March, the 2nd Quarter is from April to June, the 3rd Quarter is from July to August, and the 4th Quarter is from September to December. We will break down Kid's Toy Store annual sales of $100,000 into quarters. In The 1st Quarter of 2007, or Q1, as it is sometimes called, Kid's Toy Store had revenues of $15,000. Sales in the 2nd Quarter was 17,000. They sold $23,000 in the 3rd Quarter and $45,000 in the 4th quarter. Their expenses (liabilities) are also computed on a quarterly basis.

Revenues 2007
1st Qtr - $15,000
2nd Qtr - $17,000
3rd Qtr - $23,000
4th Qtr - $45,000
Total $100,000

We can see that Kid's Toy Store sales are increasing each quarter. This is good, but does it means the company is making money? No, not necessarily. This question cannot be answer until we compute Kid's Toy Store expenses (liabilities). Let's assume Kid's Toy Store expenses are:

Expenses 2007 - all expenses including taxes

1st Qtr - $11,000
2nd Qtr - $13,000
3rd Qtr - $20,000
4th Qtr - $22,000
Total $66,000

Kid's Toy Store revenues (sales) are greater than their expenses, therefore, they have earn a profit. But what if a company's expenses are greater than their revenues? This would be referred to as a Net Loss. This is not the case with Kid's Toy Store, but how much did they earn? Profit is computed as follows:

Revenues - Expenses = Earnings or Profit or Net Income

- 66,000
Profit $ 34,000

As noted above, the term Earnings, Net Income, or Profit can be used interchangeably. However, most of the time, Net Income is reported by dividing the earnings by the number of shares outstanding. This is called Earnings Per Share or EPS. What does the number of shares outstanding mean? This is the number of shares owned by investors (owners). Remember, when you buy shares of stock (invest), you are a percentage owner of the company. We'll assume Kid's Toy Store has 10,000 shares outstanding. Therefore, the earnings per share or EPS is $3.40.

Earnings/Number of outstanding shares = EPS

$34,000 / 10,000 = $3.40

If you are reading this sentence, Congratulations! You have come a long way and I want to encourage you to continue. Investing can be rewarding, but it does require that you spend time learning and researching.

We are still on our quest to answer the question of 'Should I buy stock in Company X?' I look forward to posting the next lesson in this series.


Number of outstanding shares - This is the number of shares owned by investors.
Earnings Per Share - Net Income (loss) / Number of Outstanding Shares.

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