Investor Basics: What Are Earnings?

Posted on April 18, 2020 at 9:04 AM PDT by

Every three months all of Wall Street seems to be frozen in place, awaiting the coming wave of corporate earnings. Stocks often stand still until the numbers come out, then prices can veer wildly up or down.

So what’s going on? Earnings, in a nutshell, are the official reporting figures of companies for each quarter of the year. Quarters end on the last day of March, June, September and December.

There are a lot of rules about how companies release earnings data. Information must be made public all at once on a set date. Usually, the earnings reports accompanied by a long, very dry management conference call with investment analysts, all of them eager to question the CEO about what the numbers mean.

The reason for all of the secrecy is fairness. If you were to get access to earnings information early and trade on it, that’s illegal. It’s the definition of insider trading.

Nevertheless, many companies issue early information as earnings “guidance” in order to avoid a nasty surprise when the actual numbers are made public. If traders were betting on a positive number that turned out to be less positive or worse, negative, that can push the price of a stock down very quickly.

Likewise, if earnings are underestimated, that can mean a stock is likely to rise in value, at least in the short run. So companies guard this data jealously and try hard to avoid leaking anything prior to the official time and date.

Earnings in practice really means profits. Did the company make more money than in the previous three months? Stock investors reward growing profitability, so establishing a trend in earnings growth is paramount for managers who rely on their own holdings in the stock to become rich.

Many companies offer their managers stock options, essentially the right to accumulate stock at a lower price than public investors in lieu of salary. If the price of the stock rises over time those managers can sell their shares, sometimes at a tremendous profit.

Yet the actual earnings report is somewhat more complex than just profits. It includes revenue — how much the company took in — as well as line items on cost of doing business, such as labor and material costs, taxes and depreciation.

Buying growth

Revenue is called “top line” and profits “bottom line” since that’s how they appear on a balance sheet. A lot of companies have huge top line numbers but a lot of costs between, so their bottom lines can be meager.

Other companies might have smaller top-line numbers but huge top-line growth. They are increasing revenues very quickly by expanding the company, opening stores, selling more product, and so on. That’s what’s known as a growth stock.

If the company can keep the costs of doing business in check, the bottom line also increases quickly. That type of growth typically attracts investors, driving up the price of the stock.

In the end, an investor is attempting to own a portion of those profits at a low cost. If a share price is low but profits are increasing, that’s a good deal for investors. So they buy more shares and the price of the stock goes up.

Over time the share price might catch up with profit growth, leading to less investor interest. Or the company might run out of room to grow and the top line slows down. An equilibrium sets in, unless the company innovates or otherwise finds a way to grow fast again.

All of this information is contained in quarterly earnings, making that data the most important data an investor can learn about a stock before buying.

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