Earnings

What Are Earnings?

A company's earnings are its after-tax net income. This is the company's bottom line or its profits.

Earnings are perhaps the single most important and most closely studied number in a company's financial statements. It shows a company's real profitability compared to the analyst estimates, its own historical performance, and the earnings of its competitors and industry peers.

Earnings are the fundamental determinant of a public company's share price because they can be used in just two ways: They can be invested in the business to increase its earnings in the future, or they can be used to reward stockholders with dividends.

Understanding Earnings

Earnings are the profit that a company produces in a specific period, typically defined as a quarter or a year. After the end of each quarter, analysts hang tight for the earnings of the companies they follow to be released. Earnings are studied because they represent a direct connection to company performance.

Earnings that deviate from the expectations of the analysts that follow that stock can have a great impact on the stock price, in the short term. For instance, assuming analysts on average estimate that earnings will be $1 per share and they come in at $0.80 per share, the price of the stock is likely to fall on that "earnings miss."

A company that beats analysts' earnings estimates is looked on well by investors. A company that consistently misses earnings estimates might be considered an unattractive and dangerous investment, or needs to improve its financial forecasting abilities for better earnings guidance yet its stock price gets harmed in the process.

There are exceptions to these outcomes depending on the circumstances of the company. For example, Amazon (AMZN) missed its estimates for several quarters in the early 2000s while it was building out its different business units. Some investors were able to understand the long-term potential, and it continued to draw in investors.

The opposite example is Google, a company known for underpromising and overdelivering. Hence, Google has repeatedly beat earnings expectations. However, that's what the analysts' community understood and started to embed Google's conservative strategy into the EPS expectations.

Generally, a new, entrepreneurial company that is seen as having strong potential can survive a few disappointing quarters, however it generally needs a decent explanation for the earnings miss. Similar to the case for Amazon, that explanation was a heavy investment in future earnings.

Measures of Earnings

There are many measures and uses of earnings. Some analysts like to calculate earnings before taxes (EBT), otherwise called pre-tax income. Some analysts prefer to see earnings before interest and taxes (EBIT). All things considered, other analysts, essentially in industries with a high level of fixed assets, prefer to see earnings before interest, taxes, depreciation, and amortization, otherwise called EBITDA.

Each of the three figures provide changing degrees of measuring profitability.

Earnings per share (EPS) is a commonly cited ratio used to show the company's profitability on a per-share basis. It is calculated by partitioning the company's total earnings by the number of shares outstanding.

Price-to-Earnings

Earnings are likewise used to determine a key indicator known as the price-to-earnings (P/E) ratio.

The price-to-earnings ratio, calculated as share price divided by earnings per share, is used by investors and analysts to compare the relative values of companies in the same industry or sector.

The stock of a company with a high P/E ratio relative to its industry peers might be considered overvalued. A company with a low price compared with its earnings could appear to be undervalued.

Earnings Yield

The earnings yield, or the earnings per share for the latest year period divided by the current market price per share, is another approach to measuring earnings. It is as a matter of fact simply the inverse of the P/E ratio.

Analysis of Earnings

Since corporate earnings are such an important metric and have a direct impact on share price, managers might be tempted to manipulate earnings figures. This is both illegal and unethical.

Some companies attempt to influence investors by prominently displaying their earnings on their financial statements to hide deficiencies reported lower down that reveal weaknesses like questionable accounting practices or an unanticipated drop in sales. These companies are said to have a poor or weak quality of earnings.

The earnings per share number may likewise be inflated with share buybacks or other methods of changing the number of shares outstanding. Companies can do this by repurchasing shares with retained earnings or debt to make maybe they are generating greater profits per outstanding share.

Other companies might purchase a smaller company with a higher P/E ratio to bootstrap their own numbers into a favorable territory.

When earnings manipulations are revealed, the accounting crisis that follows often leaves shareholders on the hook at rapidly declining stock costs.

Highlights

Earnings are a key figure used to determine a stock's value.
Earnings have a big impact on stock price, and as a result, the numbers are subject to potential manipulation.
A company's earnings are used in numerous common ratios.
Earnings refer to a company's profits in a given quarter or fiscal year.