What are earnings?
The profits of a company are its net income after taxes. This is the bottom line of the business or its profits.
Earnings are perhaps the most important and most studied number in a company’s financial statements. It shows the actual profitability of a company compared to analyst estimates, its own historical performance, and the earnings of its competitors and industry peers.
Profits are the main determinant of the share price of a public company because they can only be used in two ways: They can be invested in the business to increase its profits in the future, or they can be used to reward shareholders with dividends.
- Earnings refer to a company’s earnings in a given fiscal year or quarter.
- Earnings are a key figure used to determine the value of a share.
- The profits of a company are used in many common proportions.
- Earnings have a huge impact on the share price, and as a result, the numbers are subject to possible manipulation.
Understand the earnings
Profits are the profits that a company produces in a specific period, generally defined as a quarter or a year. After the end of each quarter, analysts expect earnings for the companies that follow to be released. Profits are studied because they represent a direct link to the performance of the company.
Earnings that deviate from the expectations of analysts following that stock can have a big impact on the stock price, at least in the short term. For example, if analysts estimate earnings on average to be $ 1 per share and at $ 0.80 per share, the stock price is likely to fall due to this “loss of earnings.”
Investors look favorably on a company that beats analysts’ earnings estimates. A company that constantly loses earnings estimates can be considered an unattractive and risky investment.
There are exceptions to these results depending on the circumstances of the company. For example, Amazon (AMZN) failed to meet its estimates for several quarters in the early 2000s as it developed its various business units. Some investors were able to understand the long-term potential and it continued to attract investors.
In general, a new and enterprising company that is considered to have great potential can survive a few disappointing quarters, although it generally needs a good explanation for lost earnings. As was the case with Amazon, that explanation was a huge investment in future earnings.
There are many measures and uses of earnings. Some analysts like to calculate earnings before taxes (EBT), also known as income before taxes. 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.
The three figures provide varying degrees of measurement profitability.
Earnings per share
Earnings per share (EPS) is a commonly cited index that is used to show the company’s profitability per share. It is calculated by dividing the total earnings of the company by the number of shares outstanding.
Earnings are also used to determine a key indicator known as the price-earnings (P / E) ratio.
Investors and analysts use the price-earnings ratio, calculated as the price of the share divided by the earnings per share, to compare the relative values of companies in the same industry or sector.
Shares of a company with a high P / E ratio relative to its industry peers can be considered overvalued. A company that is priced low compared to its earnings may seem undervalued.
Earning performance, or earnings per share for the most recent 12-month period divided by the current market price per share, is another way to measure earnings. In fact, it is 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 the stock price, managers can be tempted to manipulate earnings figures. This is illegal and unethical.
Some companies try to influence investors by prominently displaying their earnings on their financial statements to hide the deficiencies reported below that reveal weaknesses such as dubious accounting practices or an unexpected drop in sales. These companies are said to have poor or weak income quality.
The number of earnings per share can also be inflated with share buybacks or other methods to change the number of shares outstanding. Companies can do this by repurchasing shares with retained earnings or debt to make it appear that they are generating higher earnings per outstanding share.
Other companies can buy a smaller company with a higher P / E ratio to push their own numbers into favorable territory.
When earnings manipulations are revealed, the accounting crisis that follows often leaves shareholders in a hurry over rapidly falling stock prices.