Earnings and EPS

In the last video we learned a little bit about what an income statement would look like for a very kind of vanilla company that sells widgets. And in this video what I want to do is close the loop and see how this relates to what we talked about in the first video, in terms of price per share. And we'll talk about earnings per share in this case. And then also how the income statement relates to the balance sheet. And I said I would do it in the last video, but then I realized I was running out of time. And just as a bit of a quick review, and you probably just watched that video. But just in case you didn't, revenue was literally the widgets that I sold. Let's say this was for 2008. I sold $3 million worth of widgets. Cost of goods sold, well that's just the cost of the goods sold. So let's say I sold 3 million widgets for $1. To produce those 3 million widgets for $1, it cost me maybe $0.30 a widget, or $0.33 a widget. And so I had a total expense or total cost of goods sold of $1 million. And so the profit from just selling those-- say in that case that I just made up-- $3 million worth of widgets was $2 million. But I have other expenses. I can't just put that in my pocket. I had marketing, sales, general and administrative. And then I was left with $1 million. And that's how much operating profit my widget company has produced. But I'm not done yet. We learned in the last video I didn't own the company outright. I had some debt. In this case, $5 million worth of debt. So I have to pay some interest. There was 10% interest. So you take the interest out. You're left with $500,000 of pre-tax income. And of course you have to pay the government. And we can debate on whether we're paying them too much or too little. But they're providing me defense so that other foreign countries can't come and bomb my factories. And they're providing, hopefully, an educated workforce for me. And nice roads and infrastructure and electricity. So who knows? So that's what I'm paying for, arguably. And so I'm left with net income of $350,000. And when people talk about earnings of a company, this is what they're talking about. Net income is also earnings. So when someone says, Google made $4 billion this past quarter-- and quarter just means a quarter of a year, a three month period. And they normally are literally March, June, September and December. So every fourth of the year. They're literally saying, Google made $3 billion in net income. We talked in the first video when we started this series about how different companies have different numbers of shares. So let's make up a number of shares for this company. So let's say this company has-- let me do it in mauve-- so this company's shares, let's say it has 1 million shares. So you've probably heard not only the term earnings, you've probably also heard the term earnings per share. So what they do is they just take your earnings number and you divide by the number of shares. And you have earnings per share. Or EPS. Sometime people just say EPS for this company in 2008 was, and in this case you take $350,000, your total earnings, divided by the total number of shares you have. And that's what? That's $0.35 per share of EPS. Before I go into price to earnings and all that, I want to connect the dots between the income statement and the balance sheet. So in this period, I made $350,000. So the way you can think about what an income statement is, is it tells you what happens between balance sheet snapshots. So let's say on 12/31/2007, the balance sheet for the company would have looked like this. Let me just draw it. I won't use the square tool. So it had $10 million of assets. It had $5 million of debt. You can kind of view this as the liabilities of which debt is one of them. Let's just say it's all of it. So $5 million of liabilities. So the shareholders' equity, or you could almost say the book value of the equity of the company, is $5 million. $5 million equity. And just to kind of tie it a little bit with what we did in the first video, if we have a million shares, the book value of the equity is $5 million, so if we say the book value per share is just going to be this number divided by the million shares I have. So $5 million divided by 1 million is $5. This is the book value for a share. Remember, there's a difference between book value and market value. The stock of this company at 12/31/2007, it could have been trading at $10, at $7, at $1. That would have been the market value per share. This is the book value. And the book value is essentially saying, OK, if you take the book value of the assets-- and I talked about this a little bit in the last video-- but if you say, oh, well we paid $10 million, and this is how much value there. And I'll go into more detail into how you value these types of things. And you take out the liabilities, this is what the assets are worth according to the accountants. The market value could be very different. But fair enough. I don't want to delve too much into that. But now, over this period of time, over 2008, 2008 happens. So the rest of 2008 happens. And we're left at the end of, let's say 1/1/2009, or we could say 12/31/2008. It doesn't matter. Give or take a day. It's a holiday anyway. We have a new balance sheet. But what happened here? Over the course of the year, we earned some money. And I won't go too complicated into cash and accrual accounting and all that right now. We will get into that eventually. But I just want to give you the gist of what's happening. Is that we made $350,000 in this year. So our assets will have increased by $350,000. It could have increased by $350,000 of cash. It might have been increased by just other people saying they owe us $350,000. Those are accounts receivables. I'll make a whole video, probably a whole series of videos, on accounts receivables. It's an asset that says, someone owes me that money. But any way you think about it, our assets will have increased by this amount of money over the course of the year. So now, our new balance sheet at the end of 2008-- so 2008 happened. Let me draw 2008. 2008 happens. At the end of which, our assets would have grown a little bit. Our assets are now at $10,350,000. So I'll put this in thousands. This is $10,350 thousands. So that's the same thing as $10.35 million. And let's see. All we did was, we paid the interest on the debt in this example. We just paid interest. And just so you know, most corporate debt actually works that way. We'll talk later about amortization schedules and how can you pay down the debt. But unlike mortgages, a lot of corporate debt, they just pay the interest. So we still have the same amount of debt. We didn't pay down any of the principal of the debt. So we still have $5 million of debt. And what's left over for the equity? Well all of our earnings, since our debt stayed the same. All of our earnings actually fall down straight to equity. So we have $5,350,000 of equity. So the way I think about it, and probably the way you should think about it, is the earnings of a company-- in this case, we have $350,000 for the year, or $0.35 per share. They essentially tell you what happened from one balance sheet to another. So the amount that this number grows by, the amount that our equity grows by, is earnings. So this is $350,000 of earnings. And there's something I might want to touch on. Because in the last video I talked a little bit about return on asset, where we just took the operating profit, and we divide that by the assets. We had a 10% return on assets. And you might say, oh, well why shouldn't the assets grow by that amount? And the reason they didn't grow by that amount is because we actually ended up having to pay taxes on some of that. Even if we had no debt, we would still have to pay taxes. This line would have disappeared. So sometimes when people talk about return on asset-- which I did in that last video-- it might be interesting to say, is that the pre-tax or the post-tax return on asset. In this example that I did in the previous video, it was the pre-tax return on asset. But fair enough. Balance sheets are just snapshots in time. They're kind of like your bank account. How much are you worth at any one moment? And income statements tell you how do you get from one balance sheet to the next balance sheet? And we'll learn later the cash flow statement essentially reconciles the income statement with what happens with your actual cash account, or how things actually move within the balance sheet. And we'll do that later on. But anyway, we started off in this video talking about oh, what's cheap? What's expensive? So the question is, how do you determine that if you can't just go by the actual dollar price of-- my baby is crying. I should probably run to that. Let me do that right now. I realize I'm already at 10 minutes. I'll see you in the next video.