Earnings

Earnings refer to the amount of income an entity generates during a certain period. They appear on the income statement and determine a company's financial health and profitability. 

They are considered the most critical metric on a financial statement because they show a company's true profitability. 

Indeed, revenue, market cap, and other metrics generally indicate solid financial performance and reason for stock growth. 

However, these are the most important numbers when trading in the stock market. If most companies, particularly the established market leaders, report an increase, traders tend to feel more confident about the market's prospects.

• These directly correlate to a company's performance, so they're analyzed to estimate future performance and share prices.
• For example, if analysts predict that Tesla's (TSLA) earnings will be $2 per share and come in at $3 per share, the stock price will likely rise. 
• They are also vital to determining the amount of taxes a company pays, which is why they are also called after-tax net income.

Types of Earnings

An income statement shows a company's revenues, expenses, and profitability over time, also known as a profit-and-loss (P&L) statement. 

The income statement also shows many different types that measure a company's profits at different stages. Each type can indicate a company's financial health during a certain process stage. 

EBITDA

• EBITDA stands for the earnings before interest, tax, depreciation, and amortization
• EBITDA filters out hidden expenses and represents a company's operational performance

EBIT

• EBIT means a company's earnings income before interest and tax, which is also known as operating income
• EBIT removes operating expenses, such as Cost of Goods Sold (COGS) and SG&A (Selling, General, and Administrative Expenses)
• EBIT reflects a company's profitability purely based on operational performance 

EBT

• EBT stands for Earnings Before Tax. It measures a firm's revenue before taxing or adding tax benefits.
• It's extremely useful when comparing a firm to its competitors because it removes the effect of taxes.

Net Income

• Shows income after taxes is deducted. It appears at the bottom of the income statement.
• Net income is prone to accounting manipulation, unlike EBITDA and EBIT.
• It is the last line on the Income Statement and flows into the Shareholder's Equity item on the Balance Sheet (after dividends are paid) and the first line of the Cash Flow Statement.

Why is it so Important?

Of all the factors that can affect the stock price, whether its potential growth or changes to a company's leadership, perhaps the most important and straightforward is a company's post-tax net income (earnings). 

Quarterly reports are one of the most crucial metrics to investors because they reveal how much money a company earns, how much is spent, and how much is left over. 

These reports signal green or red flags to stock investors looking to move on their position.

Earnings Metrics

1. Earnings Per Share (EPS)

• Calculated by a company's profit divided by the outstanding shares of its common stock
• EPS is one of the most important numbers because it shows the number of profits that are available for distribution to shareholders
• It helps shareholders quantify the impact of the report and estimate the value of the company's shares

2. Price to Earnings Ratio (P/E Ratio)

• The P/E ratio, calculated as share price divided by EPS, is used by investors and analysts to compare the relative values of companies in the same industry or sector.
• It also is a way to tell if a stock price is high or low compared to the past.

3. EV/EBITDA Ratio

• Divides a firm's enterprise value (EV) by its EBITDA
• Ignores capital expenditures (CAPEX)
• These ratios are generally compared with the industry average and fellow competitors. If a company's EV/EBITDA and P/E ratios are higher than its peers, it might be overvalued and vice versa.

These ratios are generally compared with the industry average and fellow competitors. If a company's EV/EBITDA and P/E ratios are higher than its peers, it might be overvalued and vice versa.

How do they Affect Stock Prices?

Every three months (quarter), earnings report season is one of the most critical times for stock investors. 

It's the time to check how a company's fundamentals support market performance, reevaluate your interest in those companies and capitalize on expected price fluctuations.

The main reason behind how these reports affect a trillion-dollar company's stock price is market expectations. 

Analysts' EPS estimates set the tone for how the company is likely to perform. If actual results vary from these expectations, a stock's price can respond by moving up or down. 

However, even if EPS and other metrics do well, stock prices can still go down if they don't live up to market expectations.

For example, if Apple (AAPL), the company with the largest market cap, made money during a quarter and secured a profit, but investors were expecting sky-high net income, the failure to meet those lofty expectations can cause the stock price to fall.

Similarly, if a company revises its outlook and does not release any future expectations, then stock prices will fall. Again, this will make investors lose confidence in the management, causing them to sell the stock.

These quarterly reports can be positively skewed due to mergers and acquisitions and to truncation of earnings distribution from below, where the downside is bounded by firm value. Such changes can give investors false hope for future growth prospects.

Researched and authorized by Madhav Badithela | Linkedin

Reviewed and Edited by Aditya Salunke I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Earnings Before Interest and Taxes (EBIT)
• Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)
• Earnings Per Share (EPS)
• Earnings Per Share Formula (EPS)
• EBIT