Feel the Earn: Why Company Earnings Matter

As Their Earnings Go, So Goes Your Portfolio

Investors, take a good look in the money mirror: Your bottom line comes down to their bottom line.

In other words: How can you determine whether a company’s stock price accurately reflects its worth and deserves your financial stake?

If you can’t determine a stock’s value, you can't possibly know whether the current price is high, low, or about right. Fortunately, many resources can help you evaluate stocks.

And it's the most rudimentary of numbers that will matter most before you write that check to your broker. 

The Basics

For most investors, evaluating a stock revolves around the company’s earnings. And earnings simply are the company’s profit – how much money did it make in any given period, which is often made public every three months in what's called a quarterly earnings report.

One report on its own may not tell the full story. Small or rapidly growing companies with negative earnings, for example, may be going through a process of rapid expansion to realize their full potential. Thus, earnings reports must be read in the proper context.

Positive Earnings

Earnings (or growth towards positive earnings) tell you how healthy a company is and if it may pay dividends or grow through capital appreciation (higher stock price). 

Investors expect established companies such as Coca-Cola (KO) to have positive earnings.

If Coke reports lower earnings for a quarter, the stock will likely drop unless something explains this as a one-time event. Young companies, on the other hand, may go for years with negative earnings and still enjoy the favor of the market if investors believe in its future.  A current example is Tesla (TSLA), which has yet to report a profit as of 2016, but has investors excited over its hybrid car technology.

 

So, in addition to the actual earnings, there's the expectation of earnings. A company may report positive earnings for a quarter. But if it falls short of earnings Wall Street expects, investors may punish it and send stock prices on a nosedive. 

Think of it this way: You show up at a party with a cake. That's a plus, right? But if your guests expected a chocolate layer cake and you brought a plain old pound cake, they're not going to be happy. And Wall Street, being the hungry place it is, wants its companies to deliver the goods based on forecasts made by analyst firms. Anything short of those expected goods is a reason for disappointment.

Indeed, only on Wall Street can a company make money and see shareholders get upset – or lose money and still keep investors hopeful. 

Earnings Per Share

The basic measurement of earnings is “earnings per share” or EPS. This measurement divides the earnings by the number of outstanding shares. For example, if a company earned $12 million in the third quarter and had 8 million shares outstanding, the EPS would be $1.50 ($12 million / 8 million).

The reason you reduce earnings to a per-share basis is to compare one company to another in how they divide profit.

Two companies that each had $12 million in earnings would look the same with just those raw numbers. But if one company had 8 million shares outstanding and the other company had 4 million, the latter would have the edge on EPS.

Time Interval

You can use the earnings per share measurement in three time intervals:

  • For the previous year called “trailing earnings per share”
  • For the current year
  • For coming year called the “forward earnings per share”

Only the trailing EPS is actual. The current and forward EPS are estimates.

When you hear news commentators talk about “earnings season,” they are referring to the quarterly earnings reports companies have to file with the Securities and Exchange Commission. You can look at these reports online via the SEC site called Edgar.

Parting shot: Companies that fail to meet earnings expectations usually make the business news with reports of a falling stock price.

But if the company has taken a big beating for a small difference between expected and actual earnings, it could be a golden buying opportunity – especially if the company has been consistently profitable over the years.

In other words, don't listen to the headlines: Study the bottom lines.