Why Company Earnings Matter to Investors

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Of all the factors that can affect the price of a stock—potential growth, changes to a company’s leadership, overall market sentiment, hype, rumors, and about a dozen other elements—perhaps the most important and straightforward is a company’s earnings.

If you were considering buying an existing business, you would review its accounting records to see multiple components. These include how much money the business made in the past year (and probably longer), how much it spent to operate, and how much money was left over—i.e., its profit. Investors who buy shares of publicly owned companies want the same information.

Understanding how to interpret a company’s earnings report will help you become a better investor. In this article, we will look at the components of an earnings report and explore the different ways that earnings are expressed.

What Is an Earnings Report?

Publicly traded companies in the US are required to issue an earnings report to the Securities and Exchange Commission (SEC) every three months. This is known as a quarterly earnings report, and it reveals how much money a company earned, how much it spent, and how much is left over. Companies are also expected to report what they earn in a year in an annual earnings report.

Earnings reports are also called income statements or profit and loss (P&L) statements. 

All earnings reports are available on a company’s website, usually in the investor relations section.

Earnings reports usually include the following information:

  • Basic company and financial information: Where the company is headquartered, earnings and cash flow for the period, and a balance sheet
  • Management assessment: A synopsis of the company’s performance in a quarter or year, compared to how it did during the prior quarter and during the same period in the prior year. This section also includes future expectations, which is often referred to as guidance.
  • Qualitative and quantitative disclosures: The SEC requires companies to disclose information about accounting practices, as well ascertain quantitative and qualitative information about market risk exposures.
  • Procedures used to ensure information is accurate: A list of the efforts made by the company to comply to accuracy standards

Understanding Earnings

Stock analysts review quarterly and annual reports to assess whether a company is meeting expectations and if it appears to be on track for continued growth. If a company’s earnings for the period beat analysts’ expectations and/or its own projected earnings, the stock price often jumps higher. If a company falls short of expected earnings for a quarter, it may cause the stock price to drop.

For example, on Feb. 18, 2021, Walmart reported its financial results for the last quarter and the whole calendar year 2020 in the early morning before the stock market opened. The retailer’s earnings missed analyst expectations and the stock price fell. Walmart’s stock that day opened down, a little over 5% in trade compared to the prior day’s close, and ended the trading day down 6.48%.

But what metrics are analysts referring to when they talk about an earnings beat or miss?

Earnings Per Share

There are ways to quantify a company’s earnings that help make it more meaningful than simply listing the total amount of profit. Earnings per share (EPS) is a common metric that helps shareholders quantify the impact of that reporting period’s earnings and estimate the value of the company’s shares.

Although no single number can summarize a company’s entire financial picture, EPS is considered one of the most important because it shows the amount of profits that are available for distribution to shareholders. 

EPS is calculated by taking a company’s net income and dividing it by the number of outstanding stock shares.

When a quarterly report is issued, company leaders often discuss the performance on a teleconference or webcast known as an earnings call. They compare actual EPS to the company’s projected EPS and analysts’ expectations, and then explain why the company met or didn’t meet its expected EPS. As mentioned, differences between projected EPS and actual EPS can create volatility in the stock share price.

Price-to-Earnings Ratio

Another important financial metric that is culled from a company’s quarterly or annual report is the price-to-earnings (P/E) ratio.

A P/E ratio is a way to value the stock and can be used to compare two companies in the same industry. It also is a way to tell if a stock price is high or low compared to the past. P/E ratio also can gauge whether the stock market (as a whole or as a certain sector) is high or low compared to other periods.

A number of factors should be considered when determining if a company is worth investing in. However, when comparing the P/E ratios of two companies, the one with the smaller P/E is usually a better value.

Both EPS and P/E ratios can be measured in three basic time intervals. These are the trailing EPS or trailing P/E (the previous 12 months); the current P/E; or forward earnings or forward P/E  (the projection for the coming year).

EBITDA

Another metric that features prominently on company earnings reports and earnings calls is Earnings Before Interest, Taxes, Depreciation, and Amortization—or EBITDA. A high EBITDA is considered a sign of good financial health for the business. But one of the biggest drawbacks of this ratio is that it excludes items such as interest on debt, capital expenditure, and non-cash expenses. As such, it does not present the complete picture of the company’s finances.

When Earnings Reports Can Be Misleading

Earnings reports, in some cases, may hide more than they divulge.

Companies sometimes purposely project lower quarterly earnings in a public report than they expect privately in order to create an opportunity to soundly outperform that projection. This is called “sandbagging.” 

Sometimes companies paint a rosier picture of their financial position than is true. Inflating financial statements and misleading investors can get companies into trouble. One of the most famous examples of a company using accounting practices to boost the value of its assets and its earnings was Enron, the seventh-largest U.S. corporation at the time. In 2001, a chain of events unraveled both the company and its stock price. The SEC began an inquiry into its accounting practices and Enron restated its financial results for the prior four years. Its earnings for that period declined by $591 million, and its debt for 2000 increased by $658 million.

The company’s stock price that had grown exponentially—from $7 in the early 1990s to $90 by the middle of 2000—fell to less than $1 by the end of 2001. Investors lost billions of dollars, and Enron filed for bankruptcy in December 2001.

In this era of endless online investing commentary and unsolicited advice, plenty of emotion can get wrapped up in investment decisions. A more deliberate approach that includes analyzing earnings reports will serve you well as you determine if an investment is right for you. 

Key Takeaways

  • Earnings refer to a company’s net profit for a quarter or a fiscal year.
  • Earnings help investors determine if a stock is properly valued.
  • Earnings metrics, such as earnings per share (EPS) or the price-to-earnings (P/E) ratio, can help investors compare different stocks. Earnings can be measured in terms of past performance, current year, or future (projected) earnings.
  • Sometimes companies offer lower guidance in order to outperform expectations, indulging in what is called sandbagging.