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In this tutorial, you will learn about corporate earnings and why they are important to you as an investor. You will learn what goes into corporate earnings and how to use earnings information to make a decision about investing in a corporation. You will progress through the following topics:
WHAT ARE COMPANY EARNINGS?
Business 101: You go into business to make money. Unless an organization is a not-for-profit enterprise, its goal is to make money for the owners. In order to make money, the business must have income to pay its employees, utility bills, costs of production and other operating expenses. If a company has cash left over after paying its expenses, it has earnings. Earnings are a company's net profit.
The nature of a business defines how it makes earnings. Two sources of company earnings are income from sales of goods or services and income from investment. For example, a manufacturer produces goods for sale to its customers. A bank sells depository services to its customers. All businesses generate income by providing either goods or services to customers.
Another source of income is investment. Investments generate income for businesses and individuals from either interest on loans, dividends from other businesses, or gains on the sale of investment property.
Company earnings are the sum of income from sales or investment after paying its expenses.
Sounds simple enough, but what does this have to do with you?
WHY ARE EARNINGS IMPORTANT TO YOU AS AN INVESTOR?
Remember from the previous lesson that people go into business to make money. Well, if you invest in a company's stock, you gain an undivided share of the company. Typically, when a company earns more money, shareholders do as well. Meanwhile, if you invest in bonds of the company, the company uses part of its earnings to repay interest and principal on the bonds. The more earnings the company has, the more secure you can be that the company will make your interest payments. So, company earnings are important to you because you make money when the business you invest in makes money
When a company you own stock in has positive earnings, it benefits you in several ways.
- You may receive a portion of the earnings as a dividend
- The company may reinvest earnings for future growth.
- The company may invest earnings to generate additional income.
In any case, earnings are important to you because they provide a company with capital to make money for you as an investor.
WHAT MAKES UP CORPORATE EARNINGS?
Income from sales and investments produce earnings.
Before a company can sell its product or service, it incurs expenses to produce them. These expenses may include cost of materials, labor, market research, marketing, sales and distribution and overhead. Before a company can show a profit, it must first settle the costs of doing business.
The way in which a business conducts its operations is an important element to understand when evaluating a company's earnings. Companies that are devoting significant resources to creating a new product may have a relatively weak earnings now. But, if that new product catches on, profits could quickly rise and the earnings may begin to soar. Meanwhile, companies that have great earnings now, but are not investing any money to ensure that their business success will continue, may have significant problems in the future.
When evaluating corporate earnings you should not only look at the income sources, but the expenses as well. They can reveal the company's long-term strategy for making money, or uncover potential inefficiency or mismanagement.
WHERE DO YOU FIND CORPORATE EARNINGS INFORMATION?
The best place to learn about company earnings is the corporate
annual report. The annual
report contains
information on the company philosophy and its position in the marketplace.
It also contains audited financial statements. These tell you all
about the company's financial operations. You can obtain an annual
report directly from the company's public relations department or
on the Web by searching the Securities and Exchange Commission's
EDGAR database at http://www.sec.gov/edgarhp.htm.
To find information about the company's earnings, you should study
the "income statement" and "balance sheet." The income statement
shows the sources of a company's income, production costs and other
expenses. The balance sheet shows the company's overall financial
strength and potential for future growth. You can learn more about
the financial statements in our tutorials on Understanding
the Income Statement, and Understanding
the Balance Sheet.
HOW DO YOU USE EARNINGS INFORMATION TO MAKE AN INVESTMENT DECISION?
How you use this information depends upon your investment goals. If you are an income investor, you probably want to invest in a company that is paying dividends. If you are looking for long-term growth, dividends may not be as important to you. The "financials" will show you whether a company is oriented for income, growth, or a bit of both. You can get all this information from the financials. But you must compare the financials for different companies in the same industry to see which has characteristics best suited to your investment goals.
A convenient way to compare companies is through earnings per share (EPS). EPS represents the net profit divided by the number of outstanding shares of stock.
When comparing earnings per share of several companies that are candidates for your investment dollars, here are a few things for which to look. Companies:
- With higher earnings are stronger than companies with lower earnings.
- That reinvest their earnings may pay low or no dividends but may be poised for growth.
- With lower earnings, and higher research and development costs, may be on the brink of a breakthrough (or disaster).
- With higher earnings, lower costs and lower shareholder equity, may be a target for a merger.
When comparing different companies' earnings you should ask yourself,
- Why are they different?
- Do the differences make sense for these companies?
This concludes our brief introduction tutorial about understanding company's earnings. By now, you should know what earnings are, how they are calculated and why they are important to investors. You also know how to find current earnings information.
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