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Some characteristics of a “good” company may include competitive advantage, above-average management, and market leadership. However, investors commonly look to financial indicators such as stable earnings, return on equity (ROE), and a company’s relative value compared with those of other companies to determine a firm’s potential.
Key Takeaways
- Earnings reports help investors the financial success of a company.
- Earnings may be measured with three metrics: growth, stability, and quality.
- Investors can use Return on Equity to estimate a stock’s growth rate and the growth rate of its dividends.
Company Earnings
Earnings are essential for a stock to be considered a good investment. Without stable earnings, it isn’t easy to evaluate the financial success of company A versus company B, and what a company is worth beyond its book value. Earnings may be measured with three metrics: growth, stability, and quality.
Important
An earnings report is how publicly traded companies report financial results for a specific period. Public companies are required to file a 10-Q, quarterly report, and an annual report, or 10-K, with the Securities and Exchange Commission (SEC).
Earnings Growth
Earnings growth is shown as a percentage, in periods like year-over-year, quarter-over-quarter, and month-over-month. Growth means that current reported earnings should exceed the previously reported earnings. This metric establishes a pattern that can be charted and confirms a company’s historic ability to increase earnings.
The relative relationship of the growth rate matters. For example, if a company’s long-term earnings growth rate is 5% and the overall market averages 7%, the company’s number is not impressive. However, an earnings growth rate of 7% when the market averages 5% means the company is growing faster than the market. The company should also be compared to its industry and sector peers.
Earnings Stability
Earnings stability measures how consistently earnings have been generated over time. Stable earnings growth typically occurs in industries where growth has a predictable pattern.
Earnings can grow at a rate similar to revenue growth; this is usually referred to as top-line growth. Earnings can also grow because a company is cutting expenses to add to the bottom line. Investors need to verify where the stability is coming from when comparing one company to another.
Earnings Quality
Quality of earnings evaluation is usually left to a professional analyst, but the casual analyst can take a few steps to determine the quality of a company’s earnings. For example, if a company is increasing its earnings but has declining revenues and increasing costs, investors should research if growth is an accounting anomaly or long-lasting.
Return on Equity
Return on equity (ROE) measures the ability of a company’s management to turn a profit on the money that its shareholders have entrusted it with. In the absence of any earnings, ROE would be negative. ROE is calculated as:
ROE = Net Income / Shareholders’ Equity
Return on equity (ROE) is a snapshot of a company’s valuation. Like earnings growth, ROE can be compared to the overall market and peer groups in the sector and industry. To this point, it is also important to examine the company’s historical ROE to evaluate its consistency.
Investors can use ROE to estimate a stock’s growth rate and the growth rate of its dividends. These two calculations make an easier comparison between similar companies. To estimate a company’s future growth rate, investors multiply the ROE by the company’s retention ratio. The retention ratio is the percentage of net income that is retained or reinvested by the company to fund future growth.
Researching Company Data
The world of stock picking has evolved. Historically, stock analysts and brokerage firms held all of the data for investors. In 2024, only 9% of American investors surveyed used a human financial advisor to manage their investments, according to a study by ComparisonAdviser.
Since the majority of online information is free, the debate is whether to use free information or subscribe to a premium service. A rule of thumb is, “You get what you pay for.” A free site commonly provides raw data across company sectors. However, a financial advisor might be a better source to “scrub” the data or point out the accounting anomalies, enabling a clearer comparison.
Why Is Historical Earnings and ROE Data Important for Investors?
When investors see consistent earnings and ROE data, they validate that a company has established a pattern that it can consistently deliver to shareholders.
What Comparisons Should Investors Make When Evaluating a Company’s Financial Data?
None of the metrics used to value a company should stand alone. Investors should not overlook relative comparisons when evaluating whether a company is a good investment. This means comparing financial data with a company’s competitors within its sector and with the overall market.
What Does a High Return on Equity Mean?
ROE measures a company’s profitability and how efficiently it generates profits. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing.
The Bottom Line
Stable earnings growth is important, but its consistency and quality need to be evaluated to establish a pattern. ROE is one of the most basic valuation tools in an analyst’s arsenal but should only be considered the first step in evaluating a company’s ability to return a profit on shareholder’s equity.
