Today’s Masterclass looks at Earnings and what it is and what does it tell you. A company’s earnings are its profits after tax, or other names are return, net income, bottom line and how much is made. At times Earnings is used to mean just the Sales or Revenue, but generally the Profit or Return is being referred-to.
In summary, we take total sales or revenue then subtract all the costs to produce that product (cost of sales), then take away the expenses/overheads and we have Earnings. Generally investors want to see that a company is creating a result/earnings – that it makes a profit, otherwise there is no return for investing their money.
Using Earnings to compare companies
Because every company has a different number of shares owned by the public, just comparing only companies’ Earnings figures does not indicate how much money each company made for each of its shares, so we need earnings per share (EPS) to make valid comparisons. To compare the earnings of different companies, investors use the ratio of EPS, calculated by taking the earnings / profit and divide it by the number of shares outstanding.
For example, two companies that both have Earnings after tax of $1 million but one has 1 million shares outstanding while the other has only has 100,000 shares outstanding. The first has EPS of $1 per share ($1 million/1 million shares) while the second has EPS of $10 per share ($1 million/100,000 shares).
This is not enough to judge one company better though.
An investor would also ask which has a better profit margin?
Which has more manageable debt?
Which has a better return on assets, return on equity etc etc?
Earnings season is the regular time of year that publicly-traded companies publish their financials – twice a year in Australia, and quarterly in the USA. Most companies follow the calendar year for reporting, but they do have the option of reporting based on their own fiscal calendars.
Earnings (or EPS) is one of the most important numbers released during reporting/earnings season, and before earnings reports come out, stock analysts issue earnings estimates – what they think the company earnings will be. These forecasts are then compiled by research firms into the “consensus earnings estimate”.
When a company beats this estimate it’s called an earnings upside or surprise, and the stock usually moves higher.
If the earnings are below these estimates it is said to disappoint, and the price typically moves lower.
This makes it hard to try to guess how a stock will move during earnings season: it’s really all about expectations.
What is the importance of Earnings?
Investors care about earnings because that ultimately drive stock prices. Strong earnings generally result in the stock price moving up (and vice versa). Sometimes a company with a rising stock price might not be making much money, but the rising price means that investors are hoping that the company will be profitable in the future .
When a company is making money it has two options. First, it can invest back in the company – improve its products and develop new ones and make more profit. Or second, it can pass the money onto shareholders in the form of a dividend or use it in a share buyback.
In all, growing earnings are a good indication that a company is on the right path to providing a return for investors.
Want to learn the core issues of share investing? Our slides SMSF & Shares Overview gives a quick session to learn to easily understand Company Financial Statements, how to find healthy companies, what tools and ratios to use, work on examples, and also includes how to get better investment outcomes.