Earning Potential
What Is Earning Potential?
Earning potential refers to the potential gains from dividend payments and capital appreciation shareholders could earn from holding a stock. In other words, it reflects the largest possible profit that a corporation can make. It is often passed on to investors as dividends. The possible growth in earnings that could be generated for each share outstanding of a particular stock.
Earning potential can be measured on an earnings per share (EPS), return on assets (ROA) or return on equity (ROE) basis. Companies sometimes choose to pass this growth on to investors as dividends.
How Earning Potential Works
As well as investigating earnings growth potential, analysts, investors, portfolio managers, and potential acquirers as a rule take a gander at a stock or industry sector's earning potential in relation to other factors like price, by working out the price to earnings (P/E) ratio. Generally, the higher the ratio, the greater the earnings potential. The perception that a given stock has higher earning potential relative to other securities tends to drive up the price of that stock.
Despite the fact that earning growth potential can cause a stock's price to rise, this won't necessarily translate into higher current dividends as company management would choose to instead reinvest its earnings in the business. A company that comes out with an innovative new product might have higher earning potential in the future as a result, yet the projected revenue may not translate into genuine profit for quite a while.
A company's market value can and does fluctuate because of reasons unrelated to its earning potential. For instance, during "risk-off" periods in markets when a change in risk perception makes investors reluctant to bet on any however the safest assets. The same dynamic can operate in reverse during times of bullish sentiment.
Examining Earning Potential
Several factors need to be taken into account when esteeming a stock's earning potential. The value of intangibles, for example, intellectual property and brand equity, share buyback plans, revenue forecasts, and market share notwithstanding management acumen, regulatory risk, and general investor sentiment — all come into play when dissecting or deciding whether or not to invest in a stock or acquire a company.
Earning potential varies by industry, so it's important to consider where a stock trades relative to its industry peers by investigating comps, or comparables. Furthermore, comparing a company's earning potential to its past performance can show you how its growth potential has changed over time.
Fundamental analysis utilizing financial ratios obtained from a company's financial statements is the basis for understanding earning potential.
Features
- Fundamental analysts utilize ratio analysis to compute a company's earning potential for investors.
- Earnings potential varies by industry and may likewise be idiosyncratic between firms inside the same industry.
- Earning potential is the expected upside that an investor can expect from holding an investment in terms of total return (capital gains plus dividends and cash flows).
