What Exactly Is The Net Income Formula?

Chris Dios - September 26, 2019

Net Income Formula

Net income – also known as net earnings – tells investors how much income a company generated over a given period. In order to calculate net earnings, we need to first determine revenues. Then, deduct all expenses from revenues to determine net earnings. That’s it. Sounds more complicated than it is, right? The actual net income formula goes like this:

Net Income = Total Revenues – Total Expenses.

Furthermore, let’s take a look at expense items. The first expense is the cost of goods sold (COGS). Subtracting Revenues from COGS yields gross profit. This shows how much it costs a company to produce sales. Next comes operating expenses. These expenses do not directly relate to the production of goods. These include salaries, utilities, and depreciation.

Finally, deduct interest expenses and taxes. After deducting all the aforementioned expenses, a company finds its net income.

Analyzing The Net Income Formula

Net earnings is a key figure that is an integral component of several important analysis ratios. Without net earnings, traders can’t calculate many of the most important financial metrics. One of the most notable ratios that rely on net earnings figures is the profit-times-earnings (PE) ratio. PE is the cornerstone ratio for most forms of equity analysis. It’s the key metric for determining the fair value of a stock.

To go even further, PE is the foundation of several other formulas that measure more aspects of a business’s fundamental value. For example, PE growth, or PEG, is a key metric for growth investors. Net earnings is also a determining factor in the payout ratio and other key statistics. To truly understand business fundamentals and equity analysis, it’s important to understand net income and what it represents.

Businesses are built on earnings, so it’s important to understand earnings metrics if you want to be a successful investor. If you understand how these figures are calculated, it provides a deeper level of understanding and utility than simply looking them up online. Before you trade stocks, you should understand how businesses calculate these important ratios.

Earnings Growth

Earnings growth is calculated by comparing net income over time. By looking at net earnings on a quarter-by-quarter basis, you can determine the rate at which the company is growing its overall earnings on a short-term basis. You can look at things from a more long-term perspective by looking at annual growth, which gives you an idea of how much earnings are growing on a year over year basis.

Positive earnings growth is a key attribute for most successful companies. There is an old saying that goes, “if a company is not growing, it’s dying” and that axiom holds true for most investors. If a company’s earnings begin to contract, it could be a bad sign for things to come. However, like most rules in investing, this one also has some exceptions.

Investors expect different things from different companies, and some growth investor may be more concerned with revenue growth than negative earnings. Therefore, stocks may react differently to earnings releases. Share prices are largely driven by sentiment, so understanding the fundamentals is only half the battle. Make sure you understand the Street’s sentiment towards a stock so you know what to expect as events develop. If it’s a small startup that is growing rapidly, many growth investors could care less about earnings as far as revenues are growing at a high rate. Conversely, a well-established company could be in big trouble if they report a quarterly operating loss.

Make sure you understand what investors are looking for so you know how share prices will react to changes in net earnings.

Final Thoughts

Don’t sleep on the net income formula. It’s foundational knowledge for any trader. Use it to calculate a stock’s inherent value or project future growth. It’s useful in so many different capacities that it’s practically impossible to make informed investment decisions without. Don’t underestimate its importance to equity analysis.

To put it simply, net income measures how much money a company earned in profits over a given period. That’s pretty important, so every trader should know how to calculate net income.

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Chris Dios is an American writer and entrepreneur based in the Greater NYC area.

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