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It's the Earnings

Earnings are the Most Important Indicator of Company Health


It all comes down to the bottom line.

Well, there’s more than one way to read that sentence and both would be correct. In this article, I am introducing the concept of stock evaluation or how you decide if a company’s stock price accurately reflects its worth.

If you can’t determine a stock’s value, how will you know whether the current price is high, low, or about right? Fortunately, there are many resources to help you evaluate stocks, although you must be careful since some of these sources may be less than objective in their analysis

The Basics

However, let’s stick with the basics first. For most investors, stock evaluation revolves around the company’s earnings. Everything else either adds to or takes away from the earnings report. Earnings simply are the company’s profit – how much money did it make in any given period.

This is not to say that small or rapidly growing companies with negative earnings have no value or that their earnings’ reports are meaningless – quite the contrary. All earnings reports have meaning in the proper context.

Positive Earnings

Investors expect established companies like Coca Cola to have positive earnings. If Coke reports lower earnings for a quarter, the stock will likely drop unless there is a reason that 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 the future of the company.

So, in addition to the actual earnings, is the expectation of earnings. A company may report positive earnings for a quarter, but fall short of expectations and see its stock tumble.

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).

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 facilitate comparison with another company and to show how to divide the profit. Two companies that each had $12 million in earnings would look the same with just those raw numbers. However, if one company had 8 million shares outstanding and the other company had 4 million shares outstanding, which stockholders will profit the most.

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 SEC.

You can look at these reports online via the SEC site called Edgar.

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

Investors use many other tools in evaluating stocks, but it all begins and usually ends with earnings.

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