Operating income is just one of the fundamental considerations you can take into account when deciding how to invest in the stock market. You find operating income on an income sheet, which contains lots of details about a business’s current financial health.
As I’ve mentioned before, stocks are a reflection of the company behind them. While stock prices don’t always correlate directly with fundamentals like operating income — especially with penny stocks — it’s more common than not.
Healthy companies inspire confidence in traders. Market experts want to buy stocks in businesses that are trending in positive directions. On the other hand, they want out of stocks that reveal negative financial indicators.
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But what is operating income? How do you calculate operating profits? And what do these terms have to do with your stock trading strategy?
What Is Operating Income?
Operating income is the profit a company realizes after paying its operating expenses and covering the cost of goods sold. Operating expenses can include things like rent, packaging, shipping fees, depreciation and amortization of fixed assets, and more.
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Have I lost you yet? I hope not.
Think about how a traditional brick-and-mortar retail store runs. It needs shelving, cash registers, sales staff, storage space, and merchandise. The store might also advertise online or via other media, which eats up some of the profits.
You get operating income after subtracting all of those expenses.
Operating expenses don’t include non-operational costs. For instance, if a business has debt, the interest it pays the bank doesn’t come out of operating income. But I’ll get into that more later.
For now, I want to focus on operating income, revenue, and how both get calculated. We’ll also take a look at how revenue and operating income influence stock prices, especially among larger companies.
Operating Income vs. Revenue
Revenue represents all the money a business brings in through the sale of products or services. For instance, if you run a business consultancy and 10 clients pay you $5,000 per month for your services, your annual revenue is $600,000.
You get operating income by subtracting the cost of goods sold and operating costs from total revenue. The cost of goods sold typically incorporates the price of merchandise, any advertising and marketing expenses, materials, labor, and so on.
Let’s say you have an e-commerce store that sells clothing. You source your merchandise from the manufacturers or brands, so your cost of goods sold would include what you pay for the merchandise. You might buy a pair of jeans for $50 from the manufacturer, then sell them for $100 to the consumer.
If you manufacture your own products, the cost of goods sold incorporates materials, labor, SKUs, and more. These costs all come out of revenue.
Generally, an increase in revenue influences stock prices in a positive way. More investors want to buy shares in companies that experience revenue growth.
What is EBIT in Finance?
EBIT is an acronym for earnings before interest and tax. It’s a calculation that’s synonymous with operating income or operating profit. You can use EBIT to determine whether a company is profitable.
It has nothing to do with capital structure, debt, or taxes, which makes it a pure figure in terms of a company’s ability to generate profit. Even if a company takes on debt, for instance, or pays a high tax rate, it can be considered successful based on its ability to move merchandise or sell services.
EBIT also represents a good indicator of a company’s earning potential. If another company was considering acquiring a business, it might consider EBIT over its capital structure to determine whether it represents a good investment.
The only difference between EBIT and operating income is that the former sometimes takes into account non-operating income. For instance, if the company has profitable investments, that income can be incorporated into EBIT. Additionally, you’ll always see operating income on a financial statement, but EBIT is typically absent.
How to Calculate Operating Income
To calculate operating income, subtract operational expenses from total revenue. An operating expense is one that contributes to a company’s day-to-day operations and typically consist of recurring costs.
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For instance, a company that owns equipment can depreciate its value and include it as part of its operating expenses.
But why would you want to know a company’s operating income?
For one thing, it suggests the company’s degree of profitability. If a company’s operating income declines, the loss in profit might concern investors. Additionally, it allows you to calculate the 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.
How Does Operating Income Influence Stock Prices?
Operating income is considered a fundamental indicator. This means that investors take it into consideration when deciding whether or not to buy shares of stock in a particular company.
When operating income increases over time, it lends credence to the company’s earning potential. A business can increase its operating income by generating more revenue, reducing its operating costs, or both.
However, it’s not always that simple.
Let’s say that Company ABC has experienced a rough quarter. Its profits are down because of economic influences, so it cuts its salaried staff by half. The company isn’t necessarily more profitable because it’s reduced its operating expenses through layoffs or a reduction in force.
That’s why stock traders have to look at the whole picture.
Similarly, as I’ll discuss in more detail below, operating income doesn’t take into account expenses unrelated to operations. If a pharmaceutical company gets sued because one of its drugs results in great harm to patients, it could still look profitable on a balance sheet. However, its reputation has taken a huge hit and its stock is likely to plummet.
Comparing EBIT and Operating Income: Examples
I’m partial to EBIT calculations because they give you a fuller picture of a company’s financial health. You can take into consideration certain non-operational costs that influence how a company is doing and how it might fare in the future.
Since EBIT is defined as earnings before interest and tax, you can incorporate other one-time or ongoing expenses. I mentioned above that a lawsuit could directly impact not only profit, but 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.
A lawsuit can result in numerous fees, including legal expenses and financial judgments. If a company is forced to pay millions in damages in a class action suit, its financial health takes a steep dive.
Additional earnings can be taken into consideration, too. Let’s say a company sells a huge asset, such as a real estate holding. It can include the sale price in EBIT, but not in operating income.
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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 represents the amount of 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 offers 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.
Operating income differs from gross profit in that it takes into consideration operating expenses.
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 falls to $150 million — a $40 million difference.
But how does gross profit influence the stock market?
Take Amazon, for instance. It announced after the first quarter of 2018 that it generated $1.6 billion in profit. As a result, the stock climbed 7 percent.
There were a couple factors at play here. First, a $1.6 billion profit is nothing to sneeze at. In fact, it’s pretty remarkable given all of Amazon’s costs. It’s producing original programming, offering two-day shipping for free to Prime members, and running a whole web services department.
Based on those factors, analysts expected the company to experience a huge drop in profit. When the exact opposite happened — its profit more than doubled — the stock price surged. This is common when a company’s fundamentals prove different from public expectation.
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It’s also one of the most exciting things about the stock market.
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. For instance, let’s say that you product just one product — we’ll go with a trampoline — and you have a manufacturing plant. You can attribute every cost related to that plant, from renting the space to paying the salaries of its employees, to direct costs. They’re associated with the production of a single product.
What Are Indirect Costs?
Indirect costs are a little more difficult to pin down. They’re typically considered operational costs that 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 create 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 constitute operating expenses that don’t specifically relate to product creation. For instance, administrative expenses are indirect costs. So are equipment depreciation and amortization.
Depreciation refers to the declining market value of a piece of equipment. As you use a forklift and time passes, the forklift’s value decreases. That’s an operating costs.
Amortization refers to the accounting practice of spreading out a piece of equipment’s cost over a long period of time — specifically, its lifetime in operations. 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. The latter 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, the selling of assets, and more.
“Income” can seem a little misleading in this context. For both operating income and non-operating income, both gains and losses come into consideration. For instance, if a company’s investment undergoes a drop in value, the number still goes into the non-operating income column.
Matching Market Capitalization With Operating Income
Now, we’re going to circle around to the stock market again. You knew I’d get there eventually, right?
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Time for a new vocabulary word: market capitalization. It sounds complicated, but it’s not. Market capitalization refers to the market value of one share of a company’s stock. Pretty simple, right?
Everything has market value. If you want to sell your used car to someone in your neighborhood, that person will likely check the Kelley Blue Book for its market value in a private-party sale. He or she doesn’t want to get ripped off.
It works both ways. 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 how market value would be of particular interest to stock traders. 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 market capitalization, multiply a company’s current share price by the number of outstanding shares in the marketplace. If a company’s stock is going for $5 per share and there are 1 million shares outstanding, it has a market capitalization of $5 million.
Based on this knowledge, we know that stock price doesn’t tell the whole story. The larger the market capitalization, the more secure and stable it becomes.
Market capitalization also allows for classification of the stock.
A mid-cap company, for instance, is likely in a growth stage. You might see short-term gains as as well as long-term gains assuming the trend continues. Large-cap companies are your Walmarts and Targets. They’re extremely stable, which makes them excellent long-term investments.
Small- and micro-cap companies are more exciting. You see far more volatility and assume more risk, but only if you don’t educate yourself. Penny stocks, for instance, fall into the micro-cap classifications. They typically have market capitalizations of $300 million or less.
How Can Traders Take Advantage of Operating Profit or Loss?
Price movement is the most important key to making money in the stock market. If a stock’s price remains the same for long periods of time, money won’t be gained or lost. You won’t see much trading activity.
It’s when a company breaks resistance or support that things get interesting. High volatility can mean ample opportunity to make money, whether you’re betting on a supernova or short-selling a stock you believe will sink in price.
Big changes in operating income often precede price movement on the stock market. You have to be ready for it, though.
Be Prepared to Benefit From This Situation
First, know your rules. What are you willing to risk, what’s your stop-loss point, and how will you pay attention to the trade? What’s your trading style?
Your rules are key to keeping you safe when trading any securities. I know mine backward and forward.
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.
Does all of this seem a little complicated? It’s actually fairly easy to understand once you immerse yourself in the world of stock market trading, but it’s no fun to go it alone.
My students benefit from watching my trades in real time and learning from both me and my top students. We’re constantly sharing advice, strategies, and tips, and we’re great about answering questions.
The Bottom Line
The stock market might seem to have little to do with accounting, but the two are actually intrinsically linked. 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 puts you in a great position to profit from price acceleration. You’ll know when to buy in and get out after information gets released.
Plus, you’ll be able to hold your own in a conversation with other finance-industry professionals. That’s always a good thing, right?