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The Importance of Earnings in Evaluating Stocks

When deciding on the purchase of a stock, an evaluation of the latter is required in order to determine whether its price accurately reflects the value of the company.

Therefore, the value of the stock should be determined in order to identify whether the price of the stock correctly meets its value. Being an educated investor requires you to gain the knowledge of reasonably evaluating the stocks. If you don't have the time and information needed to do this, you can always refer to the many sources that provide such evaluation. However, you should be careful when using them, because many of them are not objective enough. 

Stock Evaluation Fundamentals

Stock evaluation involves the examination of the earnings that the company generates for its shareholders. Generally, the earnings represent the profit that the company makes through its activities. These earnings are fixed to a particular period of time.

When examining the earnings of a company, you should do this in the particular context. This is required since a small or rapidly growing company may have negative earnings. However, this doesn't mean that the company has no value at all.

Large companies with established name on the market may experience drop in their earnings. As a result the price of the stock will also decrease. On the other hand, small companies may operate with negative earnings for longer time and still enjoy high stock prices if the investors and the market as a whole believe in its future profitability.

As a result the expectations regarding the future earnings of the company also play a major role for the price level of a stock. For instance, if a company has increased its earnings, but doesn't enjoy positive attitude by the market and the investors, its price may decrease regardless of the positive earnings.

Earnings are generally viewed as a basis for analyzing a company's health. They also indicate whether the company will be able to pay dividends to its shareholders. What is more, earnings signify the possibility of the company to grow by appreciating its capital.

Earnings per Share (EPS) Formula

Earnings per Share represent the measurement, which is used to calculate earnings. It is calculated as follows:

EPS = Earnings / Number of Outstanding Shares

Example: Company ABC has $15 million in earnings for the first quarter of the year. During this period it has 6 million outstanding shares. Therefore, its EPS is $2.5, which is received by dividing $15 million by 6 million.

EPS facilitates the comparison between two companies. It also provides illustration on how the profit the company has made will be divided among its shareholders. For, example if both companies have made an equal amount of earnings, but the one has more shares outstanding than the other, shareholders of the company with less shares outstanding will profit more.

EPS Time Intervals

EPS estimations can be used in three time intervals. They are:

  1. Trailing EPS - applies for the past year
  2. Forward EPS - applies for the next year
  3. Current EPS - applies for the current year

The forward and current EPS represent estimates, whereas the trailing EPS provides an actual EPS.

From time to time, the media comment on the earnings season. The latter represents the time when the companies are required to file their quarterly earnings to the SEC.

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