Investing Intelligently: Part 3 (Does the company have a track record of increasing profitability?)

In the previous installments of this series, we looked at whether we had a sufficient understanding of a company's business model, and whether the company had a track record of meaningful sales growth. The third step keeps us on the company's Income Statement, and assessing the company's ability to improve profitability.

A publicly-traded company will report two forms of costs and expenses that affect whether it is able to increase its profitability from one period to the next. For convenience, let's stick with Apple's (Ticker: AAPL) most recent 10-K filing and the Income Statement contained therein (page 56). Here you will see that in Fiscal Year (FY) 2009 its sales increased to $36.5 billion from $32.5 billion in the same period a year ago. If we go up to page 45 of the report, the company reveals that this sales growth was driven largely by iPhone sales and Mac laptops sales; it also reveals that its iPod sales and desktop sales lagged behind the growth of its iPhone and laptops.

The first form of costs that are deducted from the top line (its net sales) is the cost of goods or what it titles as "cost of sales." These are the costs necessary to actually produce the goods it sold. You will see that in FY2009 its cost of sales increased to $23.4 billion, up from $21.3 billion in the prior period. When we deduct these costs from the top line, we see that its gross margin in 2009 was $13.1 billion. With this data we can compute its gross profit margin by taking its gross margin of $13.1 billion and dividing it by its net sales of $36.5 billion -- for FY2009 its gross profit margin was roughly 36%. This figure by itself doesn't tell us a whole lot. But if we compare it to its gross profit margin in 2008 we see that its profitability at the production stage of its operation increased from roughly 34% in 2008 to 36% in 2009. That's good. We want companies that are able to improve production profitability from one period to the next.

The other expenses taken out of net sales is "Selling, General, and Administrative" (SG&A) and Research & Development; these are the additional costs to run the business that are on top of the direct costs to produce goods. We want to determine what the company's operating profit margin is in comparison to previous periods. For Apple, by dividing its operating income of $7.66 billion by its net sales of $36.54 billion, we find that its operating profit margin in 2009 was roughly 21%; in 2008, its operating profit margin was 19.3%. Again, this is good -- Apple's gross profit margins and operating profit margins are both showing improvement.

Because of Apple's efforts to improve its production and operating profitability, net income increased substantially in 2009 by all almost 18% to $5.7 billion, up from $4.8 billion in the year ago period. We want companies that are showing double-digit revenue growth, AND, double-digit earnings growth. This indicates that not only is there a strong market for the company's goods and services, but also that the company knows how to properly run its business.

Now we are done with the Income Statement. Once you do this a few times, you will find that to do step 2 (identify sales growth) and compute step 3 (identify profitability), will only take a couple minutes at most. In the next step we will turn to the Balance Statement to identify its financial health (cash/debt), and determine what its inventory levels are telling us.

Peace

JM