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Understanding Earnings

Wall Street analysts are infatuated with earnings. Simply put a company's earnings are its profits. Earnings are calculated by taking a company's revenue and subtracting all the costs to produce the product or service. Of course the details of the accounting get a lot more complicated but underneath all the financial jargon what is really being measured is how much money a company makes. 

To compare the earnings of different companies investors and analysts often use the earnings per share (EPS) ratio. To calculate EPS the earnings left over for shareholders is divide by the number of shares outstanding. You can think of EPS as a percapita way of describing earnings.  Every company has a different number of shares outstanding so comparing only companies' earnings figures does not indicate how much money each company made for each of its shares so we need EPS to make valid comparisons. 

EPS Example
For example take two companies: ABCD and WXYZ. They both have earnings of $1 million but ABCD has 1 million shares outstanding while WXYZ only has 100000 shares outstanding. ABCD has an EPS of $1 per share while WXYZ has an EPS of $10 per share. 

Earnings season happens four times a year. Companies in the U.S. are required by law to report their financial results on a quarterly basis.  Earnings (or EPS) are the most important number released during earnings season attracting the most attention and media coverage. Before earnings reports come out stock analysts issue earnings estimates. Earning estimates are what they think earnings will be. These forecasts are then compiled by research firms into the consensus earnings estimate.  When a company beats this estimate it is called an earnings surprise and the stock usually moves higher. If a company releases earnings below these estimates it is said to disappoint and the stock price typically moves lower. All this makes it very confusing to try to guess how a stock will move during earnings season. 

Earnings Drive Stock Prices
Strong earnings generally result in the stock price moving up (and vice versa). Sometimes a company with a rocketing stock price may not currently be generating much revenue but the expectation is that it will in the future. The stock is pricing that possibility in ahead of time. 

Of course there are no guarantees that the company will fulfill the current expectations of investors. The dotcom boom and bust is a perfect example of company earnings coming in significantly short of the numbers investors imagined. When the boom started everybody was excited about the prospects for any company involved in the Internet and stock prices soared. 

But over time it became clear that the dotcoms would not be making nearly as much money as many had predicted. It simply was not possible for the market to support the high valuations without any earnings. As a result the stock prices of these companies collapsed. 

Whether or not the dotcom bubble was a scheme by the Wall street professionals to fleece the public remains to be seen and we may never know the real truth.  We say fleece because Investment bankers took these companies public knowing very well they were not making any money and most were losing millions. Then the analysts that worked for these firms pumped these stocks up with ridiculous price targets.  The stocks ran up to unspeakable levels from the IPO price.  Who profits from that The investment bankers insiders and the firms in on the deal.  Then they sell all their stock to the public at these lofty levels after unsuspecting newbie investors fall for the inflated price targets.  By the time they are through selling the stock has hit the top.  They would then sell short borrowing the stock in the accounts of the very people they sold their original lot of shares to.  They ride these stocks all the way down profiting twice (on the way up and now on the way down) while the public losses millions.  This is yet another example of the transfer of wealth from the small investor to the already wealthy.  

In order not to be fleeced again like the criminal acts of 1999 and 2000 the informed investor must look at earnings.  Earnings are the most important indicator of a company's financial health.  Solid earnings growth is a good indication that a company is on the right path to giving you a solid return. If the company is not making money that should raise the red flag.

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