Everything You Need To Know About Earnings By Investopedia Staff, (Investopedia.com) Contact Investopedia May 23, 2003
You can't get far in the stock market without understanding earnings. Everybody from CEOs to research analysts is infatuated with this often-quoted number. But what exactly do earnings represent? Why do they attract so much attention? We'll answer these questions and more in this primer on earnings. What Are Earnings? A company's earnings are, quite simply, its profits. Take a company's revenue from selling something, subtract all the costs to produce that product, and, voila, you have earnings! Of course, the details of accounting get a lot more complicated, but underneath all the financial jargon what is really being measured is how much money a company makes. Part of the confusion associated with earnings is caused by its many synonyms. The terms profit, net income, bottom line, and earnings all refer to the same thing. Earnings Per Share To compare the earnings of different companies, investors and analysts often use the ratio earnings per share (EPS). To calculate EPS you take the earnings left over for shareholders and divide by the number of shares outstanding. You can think of EPS as a per-capita way of describing earnings. Because every company has a different number of shares owned by the public, comparing only companies' earnings figures does not indicate how much money each company made for each of its shares, so we need EPS to make valid comparisons. For example, take two companies: ABC Corp. and XYZ Corp. They both have earnings of $1 million but ABC Corp has 1,000,000 shares outstanding while XYZ Corp only has 100,000 shares outstanding. ABC Corp. has EPS of $1 per share ($1,000,000/1,000,000 shares) while XYZ Corp. has EPS of $10 per share ($100,000/100,000 shares). For more details on the number of shares a company issues, see the article The Basics of Outstanding Shares and the Float. Earnings Season Earnings season is Wall Street's equivalent to school children getting sent home with their report cards. It happens four times a year as publicly-traded companies in the U.S. are required by law to report their financial results on a quarterly basis. Most companies follow the calendar year for reporting, but they do have the option of reporting based on their own fiscal calendars. Although it is important to remember that investors look at all financial results, you might have guessed that earnings (or EPS) is the most important number released during earnings season, attracting the most attention and media coverage. Before earnings reports come out, stock analysts issue earnings estimates - what they think earnings will come in at. These forecasts are then compiled by research firms into the "consensus earnings estimate". When a company beats this estimate it's called an earnings surprise, and the stock usually moves higher. If a company releases earnings below these estimates it is said to disappoint, and the price typically moves lower. All this makes it very confusing to try to guess how a stock will move during earnings season: it's really all about expectations. (For a look at why prices change after news reports, click here.)
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Why Do Investors Care About Earnings? The bottom line is that earnings drive stock prices. Strong earnings generally result in the stock price moving up (and vice versa). Sometimes a company with a rocketing stock price might not currently be making much money, but the rising price means that investors are hoping the company will be profitable in the future - of course, there are no guarantees that the company will fulfill the current expectations of investors. The dotcom boom and bust is a perfect example of company earnings coming in significantly short of the numbers investors imagined. When the boom started, everybody got excited about the prospects for any company involved in the Internet, and stock prices soared. But over time it became clear that the dotcoms weren't going to make nearly as much money as many had predicted. It simply wasn't possible for the market to support the high valuations without any earnings, and, as a result, the stock prices of these companies collapsed. When a company is making money it has two options. First, it can improve its products and develop new ones. Second, it can pass the money onto shareholders in the form of a dividend or a share buyback (see The Lowdown on Stock Buybacks). It really is this simple! In the first case, you trust the management to re-invest profits in hopes of making more profits. In the second case, you get your money right away. Typically, smaller companies attempt to create shareholder value by reinvesting profits while more mature companies pay out dividends. Neither method is necessarily better, but both rely on the same idea: in the long run, earnings provide a return on the investment of shareholders. Summary Earnings means profit; it's the money a company makes. Often evaluated in terms of earnings per share (EPS), this is the most important indicator of a company's financial health. Earnings reports are released four times a year and are followed very closely by Wall Street. In the end, growing earnings are a good indication that a company is on the right path to giving you a solid return.
By Investopedia Staff, (Investopedia.com) Contact Investopedia
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