An important metric in evaluating the long-term value of a company is understanding how its operating income is trending and what external factors can influence it either to rise or fall. In making this analysis, it is important to distinguish between operating and net income, although to many casual observers they seem very similar.
First, let’s discuss net income. This is a company’s profits or earnings–the “bottom line” so often discussed in business. Net income comes when you take the company’s revenue, subtract its cost of goods sold, operating costs, and other things such as depreciation, interest, taxes, payments to creditors, and so on. You then get the net income which is then divided by shares outstanding to get the earnings per share of a publicly traded company. The P/E ratio is based on this, and so net income is very commonly a main focus for investors.
Operating income is quite different. Those other things–depreciation, interest, taxes, payments to creditors–can be ignored. To get operating income, you simply take the revenue, subtract COGS, and then subtract operating expenses like selling, general & administrative expense and other expenses that are essential as part of doing business. In most cases, these will include depreciation and amortization, but not always (when they are excluded, this is called Earnings Before Interest, Taxes, Depreciation, and Amortization). When they are included, this is the more traditional operating income metric.
Whether you use operating income or EBITDA will depend on a number of factors that are unique to the company and sector you are operating in. EBITDA often is used in high-tech industries, especially software, where there is little depreciation and amortization of upfront expenses to be considered. However, it is probably a good idea to look at both operating income and EBITDA when valuing a company, whether software or in another field.
Why does these metrics matter? Simply because they look at the profitability of a business model on its own. Payments to creditors and taxes are variable costs that are exogenous to the business model–they can and do change, and whether they exist or not will not tell you if the company’s business can make a profit on its own. Operating income is an attempt at identifying the endogenous profitability of a business–and very often companies will be valued on their operating income first, net income second.
Many once unprofitable tech firms were given sky-high valuations from a retail investor’s perspective because of the focus on future operating income growth that professionals could see clearly. Hence complaints of skyhigh valuations of Amazon (AMZN) and Facebook (FB) when those stocks cost a tenth of what they do now. But sometimes the professionals are misguided by their operating income focus–hence spectacular failures and controversial stocks like GoPro (GPRO) and Uber (UBER), let alone the scandalous private company valuations of the last few years like Juicero and WeWork.
What is important for an analyst is to distinguish between these different metrics and know when to use them and how. This involves looking not only at the company from many different dimensions, but understanding which perspective matters the most and why.