A company’s profits have a direct tie to investor sentiment and how its stock performs on the market, so it’s important to know exactly how earnings affect stock prices.
When a company’s earnings are are up, its stock price is likely to follow.
As investors, we have hundreds of indicators to look at to determine if a company is one worth investing in.
Perhaps the strongest factor is a company’s earnings.
The reason for it being one of the first things potential investors look at is because earnings are an important number to use when analyzing a company’s profitability.
So here we’ll examine how earnings affect stock prices.
What Are Earnings?
Typically, public companies report earnings every quarter for that three-month period of time.
To boil it down to the basics, earnings are the after-tax net income, or the bottom line, of a company. They signify how much profit a company has earned after all other expenses are taken out of the equation, and good earnings affect stock prices in a good way — generally — and poor earnings affect it vice versa.
This is perhaps the best way to indicate how successful a business will be in the long run.
Earnings can be measured a couple of different ways:
- EBT — This is earnings before taxes, otherwise known as pretax income.
- EBIT — This takes EBT a step further and includes any interest the company has earned.
- EBITDA — One of the most commonly used indicators: earnings before interest, taxes, depreciation and amortization.
All three of these show different degrees of a company’s profitability.
There are also three different indicators to show a company’s profitability compared to its share price:
- Earnings Per Share — This is one of the most common ratios investors use to calculate a company’s profitability. It is calculated by dividing the company’s total earnings by the number of shares it has outstanding.
- Price-to-Earnings — The price-to-earnings ratio, or P/E, takes the share price of a company and divides it by the earnings per share. It is primarily used to find relative values for the earnings of companies in the same industry. A high P/E compared to others in the same industry indicates the company may be overvalued. On the other hand, a company’s P/E that’s lower than others could show the company is undervalued.
- Earnings Yield — This is the earnings per share of a company for the most recent 12-month period divided by the current market price. In simpler terms, it is the reverse of the P/E ratio.
As you can see, there are different ways to look at a company’s earnings and how those earnings affect stock prices.
What About Profits?
A company’s profits and earnings are basically the same thing. What sets them apart is the adjective describing them.
For example, you have gross profits. A company’s cost of sales are determined by gross profits. The higher the gross profit, the better a company is building its business around its core products.
Then you have an operating profit. This takes a company’s indirect costs and subtracts it from the gross profit. Indirect costs can include marketing, administrative and depreciation costs.
Finally, there is a net profit. It takes the net profit and subtracts any interest and taxes the company may have incurred during a period of time. This gives the most accurate picture of how much a company earns for every dollar of sales.
Earnings, on the other hand, typically take out all expenses and subtracts it from revenue.
Knowing the difference between earnings and profit helps explain how earnings affect stock prices.
How Earnings Affect Stock Prices
The fact that investors use earnings as a metric to invest is no secret to companies.
While it’s illegal to manipulate earnings, some companies have changed their figures to show higher earnings on their financial statements.
Additionally, in order to boost earnings, companies may hold back in making decisions like hiring additional employees, so as to improve their bottom line for a quarter.
Companies can also help boost their earnings with stock buybacks. This effectively reduces the number of outstanding shares a company has, thus bolstering their earnings and rewarding their shareholders.
So while earnings are a big factor, investors should be cautious and not look at just earnings when making a decision to invest in a company.
Regardless, it’s still important to know how the process works to see how earnings affect stock prices.