What Are Earnings?
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 main determinant of a public company's share price because they can be used in only 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.
- Earnings refer to a company's profits in a given quarter or fiscal year.
- Earnings are a key figure used to determine a stock's value.
- A company's earnings are used in many common ratios.
- Earnings have a big impact on stock price, and as a result, the numbers are subject to potential manipulation.
Earnings are the profit that a company produces in a specific period, usually defined as a quarter or a year. After the end of each 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 that deviate from the expectations of the analysts that follow that stock can have a great impact on the stock's price, at least in the short term. For instance, if 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 favorably by investors. A company that consistently misses earnings estimates may be considered an unattractive and risky investment, or needs to improve its financial forecasting abilities for better earnings guidance but its stock price gets hurt 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 various business units. Some investors were able to understand the long-term potential, and it continued to attract investors.
The opposite example is Google, a company known for underpromising and overdelivering. Hence, Google has repeatedly beat earnings expectations. However, the analysts' community understood that 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, though it generally needs a good explanation for the earnings miss. As was 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), 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. It is calculated by dividing the company's total earnings by the number of shares outstanding.
Earnings are also 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 may be considered overvalued. A company with a low price compared with its earnings might appear to 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. It is in fact simply 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 is both illegal and unethical.
Some companies attempt to sway investors by prominently displaying their earnings on their financial statements in order to hide deficiencies reported lower down that reveal weaknesses like dubious 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 also 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 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 a favorable territory.
When earnings manipulations are revealed, the accounting crisis that follows often leaves shareholders on the hook for rapidly declining stock prices.