What are Earnings?
Earnings refer to the income that an individual or organization gains during a certain period. They can be found on a company’s income statement and are used to measure the profitability of that company.
Higher recurring earnings usually indicate better financial performance and can positively impact stock prices. However, the calculation of earnings is subject to accounting manipulation. Thus, both the accounting quality and earnings quality should be considered when analyzing the earnings of a company.
- Earnings refer to the income that an individual or organization gains during a certain period.
- EBITDA, EBIT, EBT, and net income can be calculated from the top to bottom of an income statement.
- Earnings can be used in relative valuation through the ratios such as P/E and EV/EBITDA.
- Comparing earnings with balance sheet accounts (ROE and ROA) helps to measure the efficiency that a company uses its capital and assets to generate incomes.
Types of Earnings
There are different types of earnings from the top to bottom of income statements. Such earning measures show the profits that a company can gain at different stages. They together can show a clear and comprehensive picture of a company’s financial health.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA measures the earnings before taking the taxes, costs of financing, and costs of capital investments into consideration. Companies with large amounts of depreciable or amortizable assets – such as buildings, manufacturing machines, and patents – usually see large gaps between their EBITDA and operating income.
EBITDA strips out the obscure and extraneous expenses and can thus reflect a company’s operational performance more clearly. It is also more difficult for companies to manipulate their EBITDA. However, since the U.S. GAAP does not require companies to disclose their EBITDA, the calculation of EBITDA might vary for different companies.
Earnings Before Interest and Taxes (EBIT)
EBIT is also known as operating income. It is calculated by deducting the operating expenses from the total revenues. The operating expenses include the cost of goods sold, depreciation and amortization costs, SG&A, and other expenditures incurred by the company’s normal operation.
The EBIT metric strips out the impact of taxes and the cost of financing. It reflects a company’s profitability purely based on its normal operations. A company with greater amounts of debt might show higher EBIT but lower net income than one with smaller amounts of debt.
Earnings Before Taxes (EBT)
EBT measures a firm’s earnings before taking out its taxes or adding tax benefits. It shows a company’s operating and non-operating earnings. Effective tax rates usually vary between different companies and years. Thus, removing the effects of taxes can better reflect a company’s profitability when comparing it with peers or identifying a trend year over year.
Net income, also known as net earnings, can be calculated by deducting the taxes from EBT. It appears at the bottom of an income statement and takes all the factors and expenses into account. It is the earnings attributable to the company’s shareholders. Net income can either be distributed to shareholders as dividends or retained by the company for future investments.
Compared with EBITDA and EBIT, net income is more susceptible to different accounting methods. Since it includes obscure expenses, it is also more likely to be manipulated.
Earnings Per Share (EPS)
EPS is calculated by dividing the net earnings of a company by the number of common shares outstanding. It measures the money that the company earns for each share of its stocks. There are two types of EPS:
- Basic EPS does not consider the dilutive effects that can be caused by stock options, warrants, convertible bonds, and other items.
- Diluted EPS assumes that all the potential shares outstanding have been issued. Diluted EPS is generally lower than basic EPS. In rare cases with anti-dilutive securities, it is also possible for the diluted EPS to be higher than the basic one.
Use of Earnings
Earnings are significant measures that reflect a company’s financial performance and is commonly used in company valuations. In relative valuation, the earnings of a company are often compared with its market values to identify whether the firm is fairly valued relative to its peers. The price-to-earnings (P/E) ratio and the EV/EBITDA ratio are some of the most commonly used ones.
- The P/E ratio divides the market price of a stock by the most recent 12-month EPS of the company. The ratio tells how much investors are willing to pay for every dollar the company earns.
- The EV/EBITDA ratio divides a company’s enterprise value (EV) by its EBITDA. It is less impacted by accounting manipulation than the P/E ratio, but it ignores the capital expenditures.
The above ratios are usually compared with the industry average. If a company’s P/E and EV/EBITDA ratios higher than its peers, it might be overvalued, vice versa.
By pairing the earnings and the balance sheet accounts of a company, an analyst can tell whether the company is operating and profiting efficiently.
- Return on Equity (ROE) is calculated by dividing the net income by the total shareholders’ equity. The ROE measures how effectively a company is using its equity to generate earnings.
- Return on Assets (ROA) is calculated by dividing the net income by assets.
Higher ROE and ROA represent a higher efficiency of using its capital resources to generate earnings.
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