What Are Earnings?
Earnings typically refer to after-tax net income, sometimes known as the bottom line or a company's profits. Earnings are the main determinant of a company's share price, because earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the long run. Earnings are perhaps the single most important and most studied number in a company's financial statements. It shows profitability compared to analyst estimates, the company's own historical performance, and relative to its competitors and industry peers.
- Earnings refer to a company's profits in a given quarter or fiscal year.
- Earnings are an important figure to use when analyzing a company's profitability.
- A company's earnings are used in many common ratios.
- It can be compared to analyst's earnings estimates, the company's past performance, or against peers within the same industry.
- Earnings can have a large impact on stock price, and as a result the figure is subject to potential manipulation.
How Earnings Are Used
Earnings are the amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year. Every quarter, analysts wait for the earnings of the companies they follow to be released. Earnings are studied because they represent a direct link to company performance.
Earnings reported that deviate from analysts' expectations can have large impacts on stock price. For instance, if analysts on average estimate that earnings will be $1 per share and they come in at just $0.80 per share, the price of the stock is likely to fall on that miss.
A company that beats analysts' earnings estimates is looked on favorably by investors. By contrast, a company that consistently misses earnings estimates may be considered an unattractive and risky investment. However, 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 various business units, but investors were able to understand the longer term potential, and consequently it continued to attract investors.
Measures of Earnings
There are many different measures and uses of earnings. Some analysts like to calculate earnings before taxes (EBT), also known as pre-tax income. Some analysts prefer to see earnings before interest and taxes (EBIT). Still other analysts, mainly in industries with a high level of fixed assets, prefer to see earnings before interest, taxes, depreciation, and amortization, also known as EBITDA. All three figures provide varying degrees of measuring profitability.
Earnings per Share
Earnings per share (EPS) is a commonly cited ratio used to show the company's profitability on a per-share basis, and is calculated by dividing the company's total earnings by the number of shares outstanding.
It is also commonly used in relative valuation measures such as the price-to-earnings ratio (P/E) ratio. The price-to-earnings ratio, calculated as share price divided by earnings per share, is primarily used to find relative values for the earnings of companies in the same industry. A company with a high P/E ratio relative to its industry peers may be considered overvalued. Likewise, a company with a low price compared with the earnings it makes might be undervalued.
The earnings yield, or the earnings per share for the most recent 12-month period divided by the current market price per share, is another way of measuring earnings, and is in fact just the inverse of the P/E ratio.
Criticism of Earnings
Since corporate earnings are such an important metric and have a direct impact on share price, managers may be tempted to manipulate earnings figures. This practice is both illegal and unethical. Some companies intentionally manipulate earnings directly higher on their financial statements to hide deficiencies in their accounting practices or to cover for unanticipated drops in sales. These companies are said to have a poor or weak quality of earnings.
Earnings per share can also be manipulated higher, even when earnings are down, 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 it appear as if they are generating greater profits per outstanding share. Other companies may purchase a smaller company with a higher P/E ratio to bootstrap their own numbers into appearing more favorable. When earnings manipulations are revealed, as in the case with Enron or Worldcom, the accounting crisis that follows often leaves shareholders on the hook for rapidly declining stock prices.