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Why Company Earnings Matter to Investors

Sebencapital

Published
03/01/24
Why Company Earnings Matter to Investors

Out of the many things that can impact a stock's price, a company's earnings stand out as one of the most significant. When considering buying a business, you'd look at its financial records, such as how much money it made, spent on operations, and the resulting profit. Investors buying shares in public companies want this same kind of information.

Understanding how to read a company's earnings report can make you a better investor. This article will go over the parts of an earnings report and how earnings are shown in different ways.

What Is an Earnings Report?

US publicly traded companies have to submit a report on their earnings to the Securities and Exchange Commission (SEC) every three months. It's called a quarterly earnings report and shows how much money the company made, its expenses, and the resulting profit. Additionally, companies must also share their annual earnings report, which details their yearly earnings.

Note

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

You can find all earnings reports on a company’s website, usually in the investor relations section.

Earnings reports typically include the following information:

  • "Basic company and financial information: An earnings report contains simple details about a company, like where it's located, how much money it made, its cash flow for a specific time, and its financial status."
  • Management assessment: "A summary of how well the company did in a certain period, like a quarter or a year, compared to its performance in the previous quarter or the same time last year. This part might also talk about what the company expects in the future, which is called guidance."
  • Qualitative and quantitative disclosures:The SEC asks companies to share details about how they handle accounting, and they also need to show both numbers and descriptions about possible risks in the market.
  • Procedures used to ensure information is accurate: A summary of the steps taken by the company to meet accuracy rules.

Understanding Earnings

Stock analysts review reports released by companies every three months (quarterly) or yearly (annually). They check if a company meets or misses the expected performance. If a company's earnings are better than predicted by analysts or the company itself, the stock price usually rises. Conversely, if a company doesn't meet expected earnings for a specific period, the stock price might drop.

For instance, Walmart released its financial results on February 18, 2021, and didn't meet analysts' expectations, causing its stock price to fall by over 5% at the opening and ending the day down by 6.48%.

But what exactly do analysts look at to determine if a company's earnings meet or miss expectations?

Earnings Per Share

There are methods to measure a company's earnings that go beyond just stating the total profit. One common way is through a metric called Earnings Per Share (EPS). This helps shareholders understand how much a company earned in a specific time and estimate the value of each share they own.

Note

While no single number can tell everything about a company's finances, Earnings Per Share (EPS) is quite crucial. It reveals the profits that can be shared among shareholders, making it one of the most significant metrics.

EPS is figured out by dividing a company’s net income by its total number of outstanding stock shares.

After releasing quarterly reports, company leaders typically hold an earnings call—a teleconference or webcast. During this meeting, they discuss the company's performance, comparing the actual EPS with the company's predicted EPS and analysts' expectations. They also explain why the company met or missed its expected EPS. These differences can often cause changes in the stock share price.

Price-to-Earnings Ratio

Another key financial measure taken from a company’s reports is the price-to-earnings (P/E) ratio.

The P/E ratio helps assess a stock's value and can compare companies in the same industry. It indicates if a stock's price is high or low compared to its history. Moreover, the P/E ratio can indicate whether the overall stock market or a specific sector is high or low relative to other periods.

Note

Several factors matter when deciding if a company is a good investment. But generally, when you compare the P/E ratios of two companies, the one with the lower P/E is often seen as a better value.

EPS and P/E ratios come in three main types based on time frames: trailing EPS or trailing P/E (the last 12 months), current P/E, and forward earnings or forward P/E (an estimate for the upcoming year).

EBITDA

Another important metric often highlighted in company reports and discussions about earnings is Earnings Before Interest, Taxes, Depreciation, and Amortization, known as EBITDA. A high EBITDA is typically seen as a positive indication of a company's financial strength. However, a major downside of this ratio is that it doesn't consider certain vital expenses like interest on debt, capital spending, and non-cash costs. Consequently, it fails to provide a full and accurate view of a company's financial situation.

When Earnings Reports Can Be Misleading

Some earnings reports might conceal more than they reveal.

Note

Sometimes, companies intentionally predict lower quarterly earnings in public reports than they actually anticipate privately. They do this to surpass those expectations and showcase better performance, a practice known as "sandbagging."

Sometimes, companies exaggerate their financial health, which can mislead investors and lead to serious consequences. Enron, once a major U.S. corporation, provides a famous example. They inflated their assets and earnings through accounting tricks. Eventually, investigations revealed the truth, causing their stock price to plummet from a high of $90 to less than $1. This led to huge losses for investors and Enron went bankrupt in 2001.

In today's world of abundant online investment advice, emotions often influence decisions. It's wise to take a careful approach, analyzing earnings reports thoroughly before making investment choices that suit your needs.

Key Takeaways

  • Earnings represent a company's overall profit for a specific period, like a quarter or a full fiscal year.
  • Earnings assist investors in figuring out if a stock has the right price compared to its value.
  • Earnings numbers like earnings per share (EPS) and price-to-earnings (P/E) ratio are useful for investors to compare various stocks. Earnings can be looked at based on past results, the present year, or future (expected) earnings.
  • At times, companies give conservative predictions to beat expectations, a tactic known as sandbagging.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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