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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, because they show profitability compared with analyst estimates and company guidance. They can also be used to compare a company's performance over time and relative with its competitors and industry peers. Companies typically report earnings on both a quarterly and annual basis, and 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.

BREAKING DOWN 'Earnings'

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. A company that beats estimates is outperforming its peers; thus, the CEO may be praised and the board may pat itself on the back. A company that misses earnings is considered to be underperforming its peers, so the CEO will be blamed and the board may elect a new chief executive.

Measures and Uses of Earnings

There are many different measures and uses of earnings. Some analysts like to calculate earnings before taxes. This is referred to as pre-tax income, earnings before taxes, or EBT. Some analysts like to see earnings before interest and taxes, or 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 measures provide varying degrees of measuring profitability.

Earnings Per Share, Price to Earnings, and Earnings Yield

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.

 

Earnings Manipulation

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 in order 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 in order to make it appear as if they are generating greater profits per 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.

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