Earnings Matter Most

What is the Value of a Company?

What does the company earn?

For a business to last, it must make money. It needs to make more than it spends, and it needs to make enough that its owners want to continue owning it. A business that continues to make money is a business worth owning.

The value of a company represents its current assets as well as its expected earnings. We're looking for companies with bright futures. We're looking for companies which will earn money. You can see this potential reflected in several important statistics.

What is Earnings Per Share?

Earnings per Share is a financial measurement which divides the total annual earnings (profit) of a company by the total number of shares. This represents the profit available to each shareholder. You might see this referred to as EPS.

Why does earnings per share matter? If you're investing in stocks which you expect to increase in value over time (not just because you hope other people will buy them), you're going to be very interested in free cash generated from real earnings. After all, you're paying for a piece of future value.

What Does the P/E Ratio Indicate?

Earnings is one facet of things; the price of the stock is another.

The Price to Earnings ratio (PE or P/E) divides the current share price by the earnings per share. This tells you how the market views the company. You can compare PE ratios between similar companies, between a company and its industry (restaurant franchise, luxury cars, home improvement stores), and between a company and its market sector (consumer goods, manufacturing).

In general, the P/E ratio tells you what price people are willing to pay right now for every dollar of earnings the produced has produced in the most recent earnings time period. This is a good tool to measure investor sentiment and can help you find discounted stocks.

What Other Earnings Measurements Matter?

While earnings, free cash flow, cash yield, and the P/E ratio are top financial indicators, there are several other (not quite as) useful ones. For example, projected earnings per share is a prediction of what the company will earn. This is an estimate—often an average of several predictions—but it can give you an idea about how other people see the company's prospects in the future.

Some investors track the PEG ratio. The Price to Earnings Growth ratio is the current PE ratio divided by the projected earnings per share. If the result is less than 1, the stock is a bargain in terms of its projected earnings. This of course relies on the accuracy of the projected earnings per share.

Earnings vs. Free Cash Flow: Which Matters More?

Reported earnings follow accrual accounting rules, which means a company can show a profit on paper while generating little or no actual cash (or the reverse). Serious value investors cross-check earnings against free cash flow, the actual cash a business generates after covering its own operating and capital needs. A company that consistently reports earnings without a matching trend in free cash flow is worth a second look; something in the accounting (inventory buildup, aggressive revenue recognition, rising receivables) may be masking weaker underlying performance.

How to Read an Earnings Report

Public companies release quarterly earnings during earnings season, alongside a call where management discusses results. When you read one, look past the headline EPS number for:

• Revenue growth—is the top line actually growing, or is EPS rising only because of stock buybacks reducing the share count?
• Margins—are gross and operating margins stable or improving, or is the company spending more to earn the same amount of revenue?
• Guidance—what does management expect for the next quarter or year, and how accurate have they been at hitting past guidance?
• One-time items—earnings can be inflated or deflated by asset sales, legal settlements, or restructuring charges that won't repeat. Adjusted earnings figures deserve scrutiny, because companies choose what to adjust away.

Understanding Earnings is Essential to Successful Investing

Even though some of these measurements seem arbitrary and the daily fluctuations of the market seem unpredictable, good companies prosper and poor companies go out of business. Simply put: a good company earns good returns every year.

Keep that principle in mind and you can avoid wasting time on stocks which promise the world and fail to deliver anything. Without reliable earnings, an investment is rarely worth your time.