62 Part 2 Fundamental Concepts in Financial Management
securities. These differences can cause two companies with identical operations to
report signi! cantly different net incomes. For example, suppose two companies
have identical sales, operating costs, and assets. However, one company uses some
debt and the other uses only common equity. Despite their identical operating
performances, the company with no debt (and therefore no interest expense)
would report a higher net income because no interest was deducted from its oper-
ating income. Consequently, if you want to compare two companies’ operating
performances, it is best to focus on their operating income.^7
From Allied’s income statement, we see that its operating income increased
from $263.0 million in 2007 to $283.8 million in 2008, or by $20.8 million. However,
its 2008 net income declined. This decline occurred because it increased its debt in
2008, and the $28 million interest increase lowered its net income.
Taking a closer look at the income statement, we see that depreciation and
amortization are important components of operating costs. Recall from accounting(^7) Operating income is important for several reasons. First, as we noted in Chapter 1, managers are generally
compensated based on the performance of the units they manage. A division manager can control his or her
division’s performance but not the! rm’s capital structure policy or other corporate decisions. Second, if one! rm
is considering acquiring another, it will be interested in the value of the target! rm’s operations; and that value is
determined by the target! rm’s operating income. Third, operating income is normally more stable than total
income, as total income can be heavily in" uenced by write-o# s of bonds backed by subprime mortgages and
the like. Therefore, analysts focus on operating income when they estimate! rms’ long-run stock values.
Allied Food Products: Income Statements for Years Ending December 31
(Millions of Dollars, Except for Per-Share Data)
Tabl e 3 - 2
2008 2007
Net sales $3,000.0 $2,850.0
Operating costs except depreciation and amortization 2,616.2 2,497.0
Depreciation and amortization 100.0 90.0
Total operating costs $2,716.2 $2,587.0
Operating income, or earnings before interest and taxes (EBIT) $ 283.8 $ 263.0
Less interest 88.0 60.0
Earnings before taxes (EBT) $ 195.8 $ 203.0
Taxes (40%) 78.3 81.2
Net income $ 117.5 $ 121.8
Here are some related items:
Total dividends $ 57.5 $ 53.0
Addition to retained earnings = Net income " Total dividends $ 60.0 $ 68.8
Per-share data:
Common stock price $ 23.06 $ 26.00
Earnings per share (EPS)a $ 2.35 $ 2.44
Dividends per share (DPS)a $ 1.15 $ 1.06
Book value per share (BVPS) $ 18.80 $ 17.60
a Allied has 50 million shares of common stock outstanding. Note that EPS is based on net income available
to common stockholders. Calculations of EPS and DPS for 2008 are as follows:
Earnings per share! EPS! (^) Common _ Net (^) shares incomeoutstanding! $117,500,000____50,000,000! $2.35
Dividends per share! DPS!
Dividends paid to common stockholders
___Common (^) shares (^) outstanding! $57,500,000___50,000,000! $1.15
When a firm has options or convertibles outstanding or it recently issued new common stock, a more
comprehensive EPS, “diluted EPS,” must be calculated. Its calculation is a bit more complicated, but you
may refer to any financial accounting text for a discussion.