One of the most crucial aspects investors monitor when evaluating companies is the money they earn. If a company fails to generate a profit, it won’t last very long in the market. And from the perspective of an investor, its stock won’t generate any meaningful return, making it a poor investment. For this reason, investors and analysts await firms’ earnings reports with great anticipation.
Navigating your way around earnings can be tricky if you’re new to investing. How exactly do you calculate it? Is there more than one way to measure it? And why do many investors prefer using the term earnings per share (EPS) rather than earnings?
What are earnings?
Earnings, also referred to as profit, are a company’s after-tax income. Companies report their earnings on the income statement every quarter and after the end of their fiscal year. The colloquial term bottom line is used occasionally, a reference to the figure’s location at the bottom of the income statement.
To determine the earnings of any firm, obtain the revenue figures and deduct the following:
- Direct expenses: Costs that directly go into producing the good or delivering the service;
- Indirect expenses: General costs associated with running the business, such as marketing, rent, and utilities;
- Interest costs: Interest charges the firm pays on its debt obligations; and
- Taxes: Corporate taxes the firm must pay.
Earnings are one of the most critical and studied figures a company reports to the public. Investors and analysts use this number extensively to assess its business performance and value its stock price. Naturally, higher earnings are preferable to lower earnings.
Companies use their earnings primarily to invest in assets to grow their business operations further. They can also distribute them to shareholders in the form of dividends.
What does EPS mean?
EPS refers to the amount of profit a company earned on a per-share basis. It’s a popular way to present, compare, and discuss earnings and is employed in financial ratios and formulas. To calculate EPS, you divide the total earnings by the number of outstanding common shares of the firm. However, online brokers readily provide EPS figures, so there’s usually no need to crunch any numbers.
How are earnings measured and analyzed?
There are several ways to measure and analyze earnings. One way is to examine the after-tax income, which accounts for every expense a firm incurs. Two widely used metrics include earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA). They’re popular among investors and analysts, because they exclude items that don’t specifically pertain to a firm’s core business operations.
EBIT measures how much a firm earned before considering interest charges and taxes. To calculate EBIT, begin with revenue and deduct direct and indirect costs, including depreciation and amortization. Using this metric, you can gauge how profitable a business is strictly from an operational standpoint and its prospects. You can also compare it with the EBIT of its competitors and the industry average.
EBITDA measures how much a firm earned before interest charges, taxes, depreciation, and amortization. To determine EBITDA, you deduct the direct and indirect costs from revenue. EBITDA is a helpful way to assess a firm’s performance from a cash flow perspective. Depreciation and amortization are non-cash expenses; excluding them gives you a clearer picture of how much cash a firm generates from its core business.
How is EPS measured and analyzed?
Many investors prefer to use EPS instead of after-tax income to measure and compare earnings, as it’s more convenient to input in financial ratios and formulas. One popular metric is the P/E ratio, which investors use to determine if a stock might be undervalued or overvalued.
In addition to the basic version previously described, firms also present EPS in other variations. One common variation is diluted EPS. This figure shows how EPS would be “watered down” should investors exercise all their convertible securities, such as bonds, options, and warrants. The conversions would increase the number of outstanding shares, thereby reducing earnings on a per-share basis. Another variation is adjusted EPS, which extracts one-time transactions unrelated to the company’s core business. An example is a substantial loss that results from a lawsuit. These transitory events don’t accurately reflect a firm’s profitability from its core operations. An adjusted EPS figure discloses this fact to shareholders.
The impact of earnings on a firm’s stock price
It’s hard to overestimate the vital impact earnings have on a firm’s stock price. An earnings report that beats analysts’ expectations can send its price soaring. Conversely, a lacklustre report can result in its price tumbling.
However, this is not always the case. For example, a company in its nascent stage may be developing new technology and not yet acquired a sizable customer base. It may need to invest heavily in research and development during its formative years to show exceptional profits in the future. Thus, a series of poor earnings reports may not necessarily depress its stock price. As long as investors feel the firm’s product has promise, they’ll gleefully invest in it, causing its share price to appreciate.