Stock Basics: Keep an Eye on Earnings

Do you own stocks or stock funds? If the answer is yes, this tutorial can help you develop a portfolio that makes sense for you. If the answer is no, this planning center has the information and advice you need to confidently place your first buy order.

Here is what you need to know about earnings.

How much does the company earn?

This is the bottom line you hear so much about. It boils down the company's year (or quarter) into a nice, neat number. Earnings per share is the company's net income (after taxes and after funds are set aside for preferred-stock dividends) divided by the number of common-stock shares outstanding.

Earnings reports may differentiate between income produced by regular operations and income from unusual transactions, such as the sale of a subsidiary.

When a company is described as growing at a certain rate, it's usually the earnings that are being used as the measure, and successful pros look for companies with a strong record of rising earnings.

How does the price relate to earnings?

Divide the current price of a stock by its earnings for the last 12-month period and you have the price-earnings ratio. The "P/E" is probably the most widely used analytical tool among stockpickers, and for good reason: It tells you what investors think of a particular stock compared with other stocks and compared with the stock market as a whole.

Actually, there are two ways to express a P/E ratio: The most common way is to use the previous year's earnings; the number is called a "trailing" P/E. Sometimes analysts use their earnings forecasts to calculate a potential P/E for a company, in which case it is called an "anticipated" P/E or something similar.

The fact that investors are willing to pay 40 times earnings for one stock and only 15 times earnings for another seems to indicate that the first stock is more highly regarded than the second, and you wouldn't go too far wrong thinking of it that way.

Perhaps investors feel more confident that the first company will be able to increase its earnings faster than the second company. Or perhaps they just expect the price of the first company's stock will rise faster than the second company's stock.

Still, a company's P/E ratio doesn't provide an investment clue until it's compared with P/E values of the same company over past years, the P/Es of other companies in the same business and the P/Es of stock indexes representing the market as a whole.

A stock selling for $10 a share with earnings of ten cents a share may seem cheap. But its P/E of 100 actually makes it vastly more expensive than a $50 stock with earnings of $2.50 a share (a P/E of 20).

A stock with an especially high P/E may be the victim of investors' unrealistic expectations. Even a slight stumble could send the price tumbling — as is the case for many dot-com or tech issues.

The idea is to buy your stock at the lowest possible P/E. As others begin to recognize the stock's potential, they may bid up the price (and thus the P/E).

That is your hope, of course, but reality doesn't always oblige. Sometimes a rise in earnings per share may actually be accompanied by a drop in price.

Why?

Because expectations were that earnings would climb higher than they actually did.

Remember: Investors buy a stock not for what it can do for them today, but for what they hope it will do for them tomorrow. If it doesn't live up to expectations, they will tend to bail out.