The net income applicable to common shares figure on an income statement is the bottom-line profit belonging to the common stockholders, who are the ultimate owners, a company reported during the period being measured. Net income applicable to common shares is the starting point for calculating the basic earnings per share and diluted earnings per share figures you always hear about on the news or when reading annual reports or 10-K filings. (To get the basic earnings per share, or Basic EPS as it is commonly known, financial analysts divide the net income applicable to common by the total number of shares outstanding.
To get the diluted earnings per share, or Diluted EPS, adjustments are made for certain potentially dilutive events or transactions, such as the exercise of employee stock options, warrants, convertible debentures, or convertible preferred stock.) The last line, at the bottom of the income statement, is the amount of money the company purports to have made - net income, total profit, or reported earnings ... it's all the same - hence the cliché, "what's the bottom line?".
- The net income applicable to common shares on an income statement is the bottom-line profit belonging to the common stockholders.
- Sometimes, shareholders are better served when management reduces risk rather than pursuing growth in net income.
- Wachovia is an example of a bank that increased risk and ended up collapsing.
Higher Net Income Applicable to Common Shares Isn't Enough to Make a Successful Investment
Many people mistakenly believe that a higher net income figure each year means the company is doing well. The problem with this approach is that it ignores changes in the capital at work. In other words, if the company's Board of Directors pushes for the firm to issue new shares of stock and, in doing so, double the total amount of money at work in the business but profits only rise 5%, that is a horrible return. That is the sort of thing we're going to discuss further into this lesson because as a new investor, the slavish devotion to constantly rising earnings per share without any attention given to return on capital is one of the most common mistakes you'll need to combat. What counts as an investor is your cut of the profit on a per-share basis over time relative to the total capital it takes to produce that return; what you, as an owner, enjoy, not what the business as a whole does.
Additionally, it's important to point out that, sometimes, shareholders are better served when management reduces risk rather than pursues growth in net income. During periods of bubbles and manias, otherwise healthy businesses can get sucked into a lot of bad behavior, pressured from sitting on the sidelines and watching its competitors get richer.
A fantastic, if tragic, example was a bank called Wachovia. Put bluntly, the collapse of Wachovia was shocking to a lot of customers and investors. Formerly one of the most respected financial institutions in its region, management decided it could increase net income applicable to common shares by going after subprime lenders during the real estate frenzy. It went so far as to roll out products like a mortgage that had a "Pick-a-Payment" feature so folks who borrowed too much could actually see their mortgage balance grow rather than amortize, increasing the bank’s risk over time.
Other businesses, such as Borders Group, formerly the second-largest bookstore chain in the country, had management teams that found the businesses they ran short of cash, ultimately landing bankruptcy court, because these firms had spent huge sums of money on share repurchases when times were good to try and drive up net income applicable to common.