What is 'Earnings Power'
Earnings power is a business' ability to generate profit from conducting its operations. It is used to analyze stocks to assess whether the underlying company is worthy of investment. A company’s earnings power is a reflection of the ability to generate income or profits over time, assuming all current operational conditions remain constant.
BREAKING DOWN 'Earnings Power'The total of all assets is often considered in earnings power, along with information regarding recent growth or loss trends. Possessing greater long-term earnings power is one indication a stock may be a good investment. Many metrics are used to solely determine a company's earnings power. For example, analyzing a company's return on assets (ROA) and return on equity (ROE) determines the company's ability to generate profit from its assets and shareholders' equity, respectively.
Earnings Power Metrics for Determining Current Business Health
A company can gain insight into the earnings power of current operations using a variety of factors. Earnings before interest and tax, referred to as EBIT, is a calculation that examines earnings power of a company based on continuous operations, and is often related to the company’s cash flow. It is based on figures taken before the payment of any interest or tax payments, and generally excludes any irregular income or expenses. EBIT provides an overview of the funds a company has at its disposal to meet any acquired debt obligations, and provides a metric to measure overall business health.
Earnings power can also be determined by some companies through an examination of the yields seen on specific securities. In regards to company stock, this most closely relates to the current dividend yield associated with the security.
Individual sectors or industries may place greater importance on certain metrics for earnings power purposes compared to others. For example, the dividend yield may be more relevant for a long-lived blue-chip company compared to a rapidly growing startup, because the startup is more likely to invest its money back into the firm to sustain its growth rather than dispense dividends.
Limits of Earnings Power Metrics
Earnings power is based on the idea the conditions surrounding business operations remain constant and in an ideal state. It does not account for any fluctuations, either internally or externally, that may affect the rate of production in any way. These risks can stem from changes within the particular market in which the company operates, changes in associated regulatory requirements, or other unforeseen events that impact the flow of business in either a positive or negative way.
Higher-than-expected earnings often result in an increase in the company’s share price. For example, when Caterpillar reported higher-than-previously anticipated third-quarter earnings in 2014, the company’s share price rose by 3.6% once the news was released.