Stocks are reflections of the companies behind them. While stock prices don’t always line up directly with company fundamentals like operating income — like penny stock companies in particular — they usually do.
Healthy companies inspire confidence. Traders want to buy stocks in businesses that are doing well, and they want out of those that look like they’re headed in the wrong direction. Operating income is one way to gauge a company’s health.
So … what is operating income? How does operating income compare to net income? How do you calculate operating income? I’ll tell you…
I’ll also explain what these terms have to do with your stock trading strategy…
Table of Contents
- 1 What Is Operating Income?
- 2 What’s the Importance of Operating Income in Business?
- 3 Does Operating Income Matter for Penny Stock Traders?
- 4 Operating Income Formula
- 5 Operating Income Examples
- 6 What Is EBIT in Finance?
- 7 How to Find the Operating Income of a Company
- 8 How to Calculate Operating Income
- 9 How Does Operating Income Influence Stock Prices?
- 10 What Are Revenue and Gross Profit?
- 11 Differences Between Operating Income and Non-Operating Income
- 12 How Can Traders Take Advantage of Operating Profit or Loss?
- 13 Apply for the Trading Challenge
- 14 Frequently Asked Questions About Operating Income
- 15 The Bottom Line on Operating Income
What Is Operating Income?
Operating income is a company’s profit after operating expenses and cost of goods sold. Operating expenses are things like rent, packaging, shipping fees, depreciation, and amortization of fixed assets…
Have I lost you yet? I hope not.
Think about how a traditional brick-and-mortar store runs. It needs shelving, cash registers, sales staff, storage space, and merchandise. It needs to advertise. You get the operating income after subtracting all those expenses.
For now, I want to focus on operating income and revenue, and how both get calculated.
We’ll also look at how revenue and operating income influence stock prices. That’s especially true for larger companies.
Operating Income vs. Revenue
Revenue is all the money a business brings in through the sale of products or services. Say you run a consulting business with 10 clients, each paying you $5,000 a month — your annual revenue is $600,000.
Or say you have an online clothing store. You sell 10 shirts for $20 apiece. That means your revenue is $200. No matter what your costs are, you still have a revenue of $200.
Revenue is known as the top line because it’s the top line on the income statement. If a company has top-line growth, that means its revenue is growing.
Generally, a revenue increase is good for a company’s stock price. Assuming its cost of goods sold isn’t too high.
Operating Income vs. Net Income
In simple terms … net income is what remains after deducting expenses from revenue. It’s an important figure since a company can report income after operating expenses but still be in the red after debt payments.
Net income is sometimes called the bottom line … because it’s the bottom line on the income statement. And because it’s the lowest amount of income after accounting for all expenses.
Operating Income vs. Profit
Profit and operating income both show the income a company’s earned, but they’re calculated using different deductions.
Profit is calculated by deducting the cost of goods sold from revenue. The cost of goods sold typically includes the price of merchandise, advertising and marketing expenses, materials, labor, and so on.
For example, if a company sold $50 worth of goods and it cost $30 to manufacture the goods, its profit would be $20.
Operating Income vs. EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It’s used as an alternative to net income. However, EBITDA can sometimes be misleading because it doesn’t count the costs of capital investments.
Companies aren’t legally required to provide EBITDA, so it’s good to know how to calculate it.
The calculation for EBITDA is:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Operating income is different because it calculates profit after all operating expenses.
What’s the Importance of Operating Income in Business?
Operating income is an indirect measure of a company’s proficiency and efficiency. Investors and company owners use it to find out how much revenue will eventually become profit.
Investors and company owners want to see high operating income. The higher the operating income, the more profitable the company is.
Managers use operating income to make daily decisions that can affect the company. That means operating income also measures management’s competence.
Does Operating Income Matter for Penny Stock Traders?
Although knowing fundamentals can add valuable information to any trader’s knowledge account. And when your knowledge account is big enough, it can start spilling into your brokerage account. That’s because you learn to think for yourself in the markets.
One of the best ways to build your knowledge account is to study my “Pennystocking Framework” DVD. It’s a guide to trading penny stocks. Jack Kellogg, who’s been through my Trading Challenge and is now up over $6 million in trading profits, still considers it one of the best resources he found in his trading journey.*
(*My results, along with the results of mentioned traders, are far from typical. Individual results will vary. Most traders lose money. These traders and I have the benefit of many years of hard work and dedication. Trading is inherently risky. Do your due diligence and never risk more than you can afford to lose.)
Operating Income Formula
Before you start using operating income as part of your trading strategy, you should know how to calculate it.
Here are the three formulas you can use:
- Operating Income = Total Revenue – Direct Costs – Indirect Costs
- Operating Income = Gross Profits – Operating Expenses – Depreciation – Amortization
- Operating Income = Net Earnings + Interest Expense + Taxes
It’s good to understand all three ways of finding operating income. Knowing each formula can help you better understand how to read financial statements. Then you can see how a company’s fundamentals affect its stock price.
Operating Income Examples
Let’s look at an example of operating income as seen on an income statement.
The highlighted areas show the rows that are used to calculate operating income.
Here’s the income statement for Amazon.com Inc. (NASDAQ: AMZN):
The yellow highlighted area is the gross profits, or total profits after subtracting costs of goods sold. Subtract total operating expenses (red highlighted area) and you’re left with the green highlighted area, the operating income or loss.
Here’s the income statement for Tesla Inc. (NASDAQ: TSLA):
What Is EBIT in Finance?
EBIT stands for earnings before interest and tax. You can use EBIT to determine whether a company is profitable.
EBIT can also be a good indicator of a company’s earning potential. A would-be acquirer might consider a company’s EBIT over its capital structure to determine whether the company might be a good investment.
Is Operating Income the Same as EBIT?
Operating income and EBIT are very similar. I’m partial to EBIT calculations because they give you a bigger picture of a company’s financial health. You can look at non-operational costs that influence how a company’s doing and how it might fare in the future.
EBIT can include one-time expenses as well as ongoing ones. A lawsuit, for example, could not only be a big hit on profit — it could also cut into a company’s future earnings potential. With EBIT, you can take that lawsuit and its costs into consideration. The same isn’t true for operating income.
Another example: If a company is forced to pay millions in damages in a class-action suit, its financial health can take a steep dive.
Additional earnings can be taken into consideration, too. Let’s say a company sells a huge asset, like a real estate holding. It can include the sale price in EBIT, but not in operating income.
How to Find the Operating Income of a Company
Finding a company’s operating income is one of the first steps in understanding a company’s financial health. If a company has a high operating income, it’s most likely doing well.
To find operating income, check out the company’s income statement. Operating expenses are listed below the gross profits and are subtracted from gross profits. When operating expenses are subtracted from gross profits, that’s operating income.
How to Calculate Operating Income
So how do you calculate operating income? You subtract operating expenses from total revenue. An operating expense is typically a recurring cost that’s part of a company’s day-to-day operations — equipment depreciation, for example.
Why would you want to know a company’s operating income?
For one, it can be a clue to the company’s profitability. If a company’s operating income declines, profit loss might be a concern.
You can also use operating income to calculate a company’s operating margin, which is the profit earned for every $1 of sales. Operating margin can be either positive or negative — if operating expenses exceed profit, the company has a negative operating margin.
Gross income is income after deducting the cost of goods sold. Even if a company’s gross income looks promising, you typically need to consider other expenses related to operating a business.
Without including operating expenses, it’s hard to get a full idea of a company’s income. Since gross income only accounts for the costs of goods sold, it’s not a clear indication of a company’s financial standing.
Operating expenses are the costs associated with running a business. The costs of the goods sold are not considered an operating expense. So what are operating expenses? Things like supplies, rent on office or retail space, payroll, and marketing costs.
These expenses can vary dramatically, so they can have a huge impact on a company’s overall profits.
Adjusted Operating Income
Adjusted operating income is not a generally accepted accounting principle (GAAP, the rules U.S. companies use when reporting earnings). But companies might have one-time streams of income — like income from a stock offering — or one-time expenses.
So the company’s operating income may need to be “adjusted” to fully disclose the income, without changing the overall financial picture.
These aren’t costs that occur every year, so accounting for them the same as other expenses would skew the company’s financials for the reporting period.
After-Tax Operating Income
After-tax operating income is another non-GAAP item, so what a company includes in its calculation can vary.
After-tax operating income isn’t as commonly used as pre-tax income, but it can be a good measure of the cash a company has available to pay debt or other expenses.
How Does Operating Income Influence Stock Prices?
A business can grow its operating income by generating more revenue, reducing its operating costs, or both. But it’s not necessarily more profitable.
That’s why stock traders have to look at the whole picture.
Operating income doesn’t take into account expenses unrelated to operations. If a pharmaceutical company gets sued because one of its drugs harms patients, it could still look profitable on a balance sheet…
But its reputation can take a huge hit, and its stock can plummet.
What Are Revenue and Gross Profit?
It’s easy to get revenue and gross profit confused. They sound like they’re the same thing, but they’re fundamentally different.
Revenue is the money a company receives from paying customers or clients. If a company sells 100,000 trampolines at $2,000 each in one fiscal year, its revenue is $200 million. Revenue can give you a comprehensive look at a company’s profitability, but it doesn’t take into account any other factors.
Gross profit, on the other hand, is revenue minus the cost of goods sold. If that same company spends $100 to make each trampoline, its gross profit is $190 million. You subtract $100 from each $2,000 trampoline.
Gross profit is a good way to determine whether a company has a decent profit margin. In other words, is it generating significant value for every dollar spent?
Let’s go back to the trampoline example. What if another company sells its trampolines for the same price, but spends $500 to manufacture each one? Given the same sales, that company’s gross profit is just $150 million — a $40 million difference.
How does gross profit influence the stock market? Take Apple Inc. (NASDAQ: AAPL). It reported gross profits of $44.3 billion for the quarter ended Dec. 31, 2020, a 25.8% increase year-over-year.
There were a couple of factors at play here. First, a $44.3 billion profit is nothing to sneeze at. It’s remarkable considering all Apple’s costs of goods sold.
Manufacturing electronics can be expensive. Especially when they’re top-notch, like Apple’s. Based on expenses, analysts expected the company to have a much lower gross profit. When Apple announced these numbers, the stock price continued to rise — it’s still trading near all-time highs.
What Are Direct Costs?
A direct cost is a predictable, specific cost related to the production of a specific product. If you manufacture and sell shoes, for instance, the leather used for a shoe’s upper is a direct cost. It’s both specific and necessary to the manufacturing of the shoe.
Materials are just one form of direct cost. Let’s say you produce just one product — we’ll go with the trampoline again — and you have a manufacturing plant. You can attribute every cost related to that plant, from renting the space to paying the workers’ salaries to direct costs. They’re all associated with the production of a single product.
What Are Indirect Costs?
Indirect costs are a little more difficult to pin down. They typically can’t be traced to a single product.
Let’s go back to our trampoline manufacturing plant. We’re adding another trampoline to the product line. The same plant will make it, and the same employees will oversee each step. None of those expenses — rent or salaries, for instance — can fall under direct costs any longer.
Indirect costs can also be things like administrative expenses, or equipment depreciation and amortization.
Depreciation refers to the declining market value of a piece of equipment. As you use a forklift over time, the forklift’s value decreases. That’s an operating cost.
Amortization refers to the accounting practice of spreading out a piece of equipment’s cost over its lifetime in operation. Instead of saying a forklift costs $25,000 the day it’s bought, you could set a $2,500 cost for every year of its 10 years in operation.
Differences Between Operating Income and Non-Operating Income
Operating income is distinct from non-operating income on a financial statement. Non-operating income is income unrelated to a company’s day-to-day operations.
The specific non-operating costs for a business will vary depending on its debts, assets, and method of operations. They could include debt liabilities, currency exchange, investments, or asset sales.
The word ‘income’ might be a little misleading in this context, because both gains and losses come into consideration. For instance, if the value of a company’s investment drops, the number still goes into the non-operating income column.
Matching Market Capitalization With Operating Income
Now, we’ll circle around to the stock market again. You knew I’d get there eventually, right?
Everything has a market value. If you want to sell your used car to someone in your neighborhood, that person will likely check for its market value in a private-party sale. If you’re trying to unload a car worth $10,000 for $5,000, the prospective buyer will wonder what might be wrong with it.
You can see why stock traders look at market value. If you know the market capitalization of a particular company’s stock, you can make a more informed decision about your trades, whether you go long or short.
To calculate the market cap, multiply a company’s current share price by the number of outstanding shares. If a company’s stock is going for $5 per share, and one million shares are outstanding, it has a market cap of $5 million.
Market capitalization is a way to classify stocks.
A mid-cap company, for instance, is likely in a growth stage. You might see short-term gains as well as long-term gains, assuming the trend continues. Large-cap companies are your Walmarts and Targets. They’re extremely stable, which can make them better long-term investment candidates.
Small- and micro-cap companies are more exciting if you ask me. You see far more volatility and assume more risk — so you have to educate yourself. Penny stocks, for instance, fall into the micro-cap classification. They typically have market caps of $300 million or less.
How Can Traders Take Advantage of Operating Profit or Loss?
It’s when a stock breaks resistance or support that things get interesting. You can potentially make money from high volatility, whether you’re betting on a supernova or short selling a stock you believe will fall.
Big changes in operating income often precede price movement in the stock market. You have to be ready, though.
StocksToTrade helps me be ready for any big changes in price action. StocksToTrade is a stock screener that was built by traders for traders. I use it first thing every morning when I wake up to build my watchlist.
StocksToTrade has killer charts and customizable scans that can help you find the best stocks that fit your trading strategies. It also has an add-on feature called the Breaking News Chat where stock news is curated for you and sent directly to your inbox. Get it now so you don’t miss out on any price-altering news catalysts.
(Quick disclaimer: I proudly helped design and develop StocksToTrade and am an investor in it.)
Be Prepared to Benefit From This Situation
If there’s been a change in a stock’s operating income, watch for the breakout point. You might see some rapid fluctuation between support and resistance, then a bull or bear flag. That’s the time to buy in.
Apply for the Trading Challenge
Does all this seem a little complicated? It’s actually fairly simple, once you immerse yourself in the world of stock market trading … But it’s no fun to go it alone.
If you’re ready to get serious, consider applying for my Trading Challenge. You’ll be able to watch my trades in real time and learn from me and top Challenge traders. We constantly share strategies and tips and answer questions.
Frequently Asked Questions About Operating Income
What Is Operating Income?
Operating income is a company’s profit after deducting operating expenses and the cost of goods sold. That includes utilities, supplies, and normal operating activities. Operating income can be helpful when evaluating a company’s overall financial health.
Is Operating Profit the Same as Operating Income?
Operating profit and operating income are interchangeable terms. They both refer to the total profit after deducting operating expenses and costs of goods sold. They don’t include outside investments, taxes, or interest expenses.
How Does Operating Income Influence Stock Prices?
Operating income can influence a stock’s price for better or for worse. If there’s steady growth in operating income, the stock’s price will most likely trend upward. The opposite is true if a company’s operating income is steadily declining.
Is High Operating Income Good?
High operating income is good for a company because it shows that the company has the potential to expand. It can be a good sign if a company has a higher operating income than other companies in its sector.
Is Discount Received on Operating Income?
When a company gives discounts on items, it cuts into revenue. Discounts received are taken into account under the revenue portion of the income statement. So they’re already accounted for before operating income is listed.
Where Is an Operating Income on an Income Statement?
Operating income is below gross profits on an income statement. That’s because operating expenses are subtracted from gross profits, resulting in operating income.
The Bottom Line on Operating Income
To understand stocks, you need to understand some accounting basics. If you don’t understand accounting, reading a balance sheet might prove impossible.
Knowing what operating income is and how it influences the stock market can help you research companies to trade. As a trader, you likely won’t use it every day, but know what it is and what it means is just another block in your market knowledge foundation. That’s always a good thing, right?
Do you consider operating income in your trades? Do you look at income statements? Let me know in the comments…