While it may seem like an obvious answer, the most important number in a company’s financial statements and the major reason why share prices go up is the company’s earnings.
However many investors get confused as to what exactly “earnings” is and whether earnings relates to a company’s revenue or its profit.
Company analysts at broking houses carefully track a company’s earnings as a guide to its share price. When earnings are going up year on year, a company’s share price tends to head in the same direction.
Companies are praised when their earnings go up and criticised when their earnings either fall or do not meet the market’s expectations (even if the company’s earnings go up, if they go up less than the market expects, the share price often gets slammed).
Therefore it’s important that we understand what company analysts are referring to when they talk about earnings. Are they referring to revenue or profit?
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Earnings refer to the amount of profit that a company generates during a given period (such as every three months in its quarterly report, every six months in its half-yearly report, or over the full year), rather than its gross revenue. Profit is a much more telling determinant of a company’s heath than revenue, which doesn’t take into account the costs of running a business.
Even if a company brings in big chunks of revenue, if its costs are high there won’t be much left over for shareholders. Take the example of a builder who makes $10,000 a day. While $10,000 a day seems like a bustling business, if the costs of building materials, equipment hire and labour add up to $15,000 a day, then the building business has a net loss of $5,000 a day. The business is not profitable, so the high revenue is of little relevance.
Stockpickers should never just look at a company’s revenue without considering its costs; in other words, stockpickers must focus on earnings and not revenue.
The definition of earnings is:
Earnings = revenue – cost of sales, operating expenses and taxes
You can find this figure on a company’s statement of financial performance under:
Net profit/loss attributable to members of…
Having stressed the importance of earnings, a negative earnings number doesn’t necessarily spell bad news. It all depends on the type of company you’re considering and where the company sits in its business cycle. Start-ups tend to post negative earnings numbers in the early years as they build the business; fast growing companies likewise might spend more than they earn in anticipation of bringing in more dollars in the years ahead. It’s your job to consider whether the negative earnings number is justified, but also to note the trend in earnings: if a company is consistently increasing earnings (or posting smaller losses) each year that’s a positive sign.
Some companies announce slightly different earnings figures to the market, such as ‘normalised earnings’ that don’t take into consideration asset writedowns and other events; these figures might just happen to be above the ‘net profit’ figure in the company’s financial statements. You need to ask the question: is the company trying to artificially boost its earnings figure to hide something?
Other figures relating to earnings that you might see will include earnings before interest and tax (EBIT), net profit after tax before abnormal items and outside equity interest (NPAT), earnings before interest, tax, depreciation and amortization (EBITDA), earnings before goodwill and so on. While these figures help to compare companies in the same industry and are important for fundamental analysts and value investors, nothing beats the bottom line figure.