Investors eagerly await earnings season because that’s when listed companies report on the cold, hard facts and figures that matter when it comes to investing in quality stocks.
For a few weeks every quarter, executives from listed companies share financial results and unpack their strategic goals and future outlook with analysts and investors via an earnings report and on earnings calls.
These reports are where astute investors – especially value investors – separate market rumours and industry trends from the facts about the health of a company and its future prospects, providing evidence to support its share price.
While expected earnings are generally priced into a share price before a company reports, any gap between what the market expects and the actual results is what causes the swing in a share price.
Positive correlation
On the most basic level, a company’s current or potential earnings is what separates speculative bets from a solid investment, because a share of stock is fundamentally a claim on a company’s future profits.
As such, a company’s earnings and its share price generally have a strong positive correlation – strong, sustained earnings growth typically leads to higher stock prices, as rising profits signal company health, driving investor demand and higher valuations.
In the short term, this relationship hinges on investor expectations. When a company beats earnings forecasts, the share price typically goes up, while missing them, even when reporting a profit, can cause share prices to fall.
Defining Earnings
Company earnings show how much profit a company has generated after the expenses of running it have been paid, including costs like salaries, operating costs and all taxes.
Also known as the bottom line or net income, company earnings are a crucial indicator of a company’s profitability, financial health, and efficiency.
However, investors may also want to compare performance across similar companies, which is when they might employ the Earnings Before Interest, Taxes, and Amortisation (EBITA) measure.
This financial metric is used to measure a company’s profitability and core operational efficiency by excluding financing costs (interest), tax obligations, and the non-cash amortisation of intangible assets.
Factors Impacting Earnings
Company earnings are shaped by a combination of internal and external factors that influence how effectively a company operates and competes in the market.
Internally, strong management plays a crucial role through sound strategic decision-making, disciplined financial control, and the ability to attract and retain skilled employees.
Operational efficiency also matters, as streamlined processes, reduced inefficiencies, and effective supply chain management help lower costs and improve profit margins. In addition, companies that prioritise innovation by investing in product development and new technologies can strengthen their competitive position and drive higher revenue.
Externally, broader economic conditions, such as rising interest rates, shifting consumer spending patterns, and high inflation, can directly affect sales and profitability.
Industry trends, including increased competition, technological disruption, and changing consumer preferences, further influence performance, while regulatory changes, ranging from environmental and labour laws to tax adjustments, can raise operating costs and place additional pressure on earnings.
Measuring the Impact
A company’s earnings relative to its share price – known as the Price-to-Earnings (P/E) Ratio – is a common metric used to see if a stock is undervalued (cheap) or overvalued (expensive).
If earnings grow while the share price remains the same, the stock becomes more attractive (a lower P/E), often triggering a wave of buying.
Another important metric investors rely on is earnings per share, or EPS. This metric measures a company’s profit allocated to each outstanding share, allowing investors to value shares based on profitability.
EPS is calculated by dividing a company’s total earnings by its number of outstanding shares, showing how much profit is allocated to each share of stock.
Professional investors also use models to calculate a company’s intrinsic value based on its expected future earnings.
When a company reports higher-than-expected profits, those models get an upgrade, and the share price usually follows suit to reflect that new, higher value.
Ultimately, basing the decision to invest in a share based on a company’s earnings focuses on the company’s current and future potential growth, rather than short-term market fluctuations, the broader economy or political landscapes. A company growing its revenue and maintaining high operating margins will likely see its share price follow.
