Earnings: The Engine of Value 🚂
If there's one number that matters most in investing, it's earnings. Let's understand why profits are the heartbeat of stock valuation.
What Are Earnings?
Earnings = Revenue - Expenses
Also called: Net Income, Profit, "The Bottom Line"
It's the money left over after a company pays all its bills—what actually belongs to shareholders.
The Lemonade Stand
Your lemonade stand brings in $100 in sales (revenue).
You spent:
- $30 on lemons and sugar
- $10 on cups
- $20 on your helper
Total expenses: $60
Earnings: $100 - $60 = $40
That $40 is your profit—what you actually get to keep. For a company, this is what drives stock value.
Why Earnings Matter So Much
1. Earnings Fund Dividends
Companies pay dividends from profits. No profits = no dividends.
2. Earnings Fund Growth
Profits can be reinvested to grow the business—new products, new markets, acquisitions.
3. Earnings Determine Value
The most common valuation method (P/E ratio) is based entirely on earnings.
4. Earnings Attract Buyers
Investors want to own profitable companies. Higher earnings = more demand = higher stock price.
Earnings Per Share (EPS)
Since companies have different numbers of shares, we use EPS to compare:
EPS = Total Earnings ÷ Shares Outstanding
| Company | Total Earnings | Shares | EPS |
|---|---|---|---|
| Company A | $1 billion | 500 million | $2.00 |
| Company B | $1 billion | 250 million | $4.00 |
Same total profit, but Company B's earnings are spread over fewer shares—each share gets more.
Key Takeaways
- Earnings = profit after all expenses
- EPS (Earnings Per Share) lets you compare companies of different sizes
- Growing earnings typically lead to rising stock prices
The P/E Ratio Connection
Remember the P/E ratio from earlier? Here's how it connects:
P/E Ratio = Stock Price ÷ EPS
If a stock is $50 and EPS is $5:
- P/E = 50 ÷ 5 = 10
- You're paying $10 for every $1 of earnings
- It would take 10 years of current earnings to "pay back" the stock price
What's a Good P/E?
- Market average: ~15-20
- Growth stocks: 25-50+ (investors expect earnings to grow fast)
- Value stocks: 8-15 (cheaper, but maybe slower growth)
- Negative P/E: Company is losing money (no earnings)
Earnings Growth: The Magic Multiplier
Here's where it gets exciting. If earnings grow, stock prices typically follow:
| Year | EPS | P/E of 15 = Stock Price |
|---|---|---|
| 1 | $2.00 | $30 |
| 2 | $2.40 (+20%) | $36 |
| 3 | $2.88 (+20%) | $43 |
| 5 | $4.15 (+20%/yr) | $62 |
| 10 | $10.32 (+20%/yr) | $155 |
A company that grows earnings 20% per year could see its stock price 5x in 10 years—even if the P/E ratio stays the same!
Quality of Earnings
Not all earnings are equal. Watch out for:
🟢 Good Earnings
- From actual business operations
- Recurring and sustainable
- Growing over time
🔴 Questionable Earnings
- One-time gains (selling a building)
- Accounting tricks
- Unsustainable cost-cutting
ShareValue.ai's Quality Score helps identify companies with sustainable, high-quality earnings.
Earnings Traps
- Focusing only on revenue (sales) without checking if it's profitable
- Ignoring one-time items that inflate or deflate earnings
- Not comparing earnings to previous years (is it growing or shrinking?)
- Assuming past earnings growth will continue forever
The Earnings Calendar
Companies report earnings quarterly (every 3 months). These "earnings reports" are major events:
- Beat expectations: Stock often rises
- Miss expectations: Stock often falls
- Guidance matters: What management says about the future
You don't need to trade around earnings—but understanding them helps you evaluate companies.
Next up: Why growth matters and how to evaluate a company's growth potential.