Understanding Earnings Season

Investors have plenty of things to worry about these days, but corporate earnings aren’t one of them. Among the Standard & Poor’s 500 companies that have reported second-quarter earnings, nearly 80% have made more than analysts had forecast, with average earnings up more than 40%, according to Reuters.

How, though, do strong earnings make shareholders richer? There are several ways, and people who own individual stocks are wise to make sure they’re getting their fair share.

Higher earnings, of course, make a company look more attractive, raising demand for the stock, driving the stock price up.

So investors should watch the price-to-earnings ratio, which is figured by dividing the current share price by earnings for the past year. If a $100-per-share stock reported $10 per share in annual earnings, the P/E ratio would be 10.

A high P/E ratio means investors are very optimistic about a company, paying more for every dollar in earnings, while a low P/E means they are pessimistic. Over the long term, the S&P 500’s P/E has averaged about 15, about where it is now.

If earnings go up and the P/E ratio stays the same, the share price goes up. If earnings rose to $12 a share and the P/E continued to be 10, the share price would be $120. The 20% gain in earnings would produce a 20% rise in share price.

If earnings go up and the share price doesn’t, it’s a sign investors see something to worry about. It could be something in the broad economy, or it could be specific to the company, like slow revenue growth or a weak lineup of new products. Of course, share prices tend to rise and fall ahead of earnings reports, according to analysts’ expectations, so a sharp move in the share price following an earnings announcement is most likely when there is a surprise, either positive or negative.

Investors should also look at what a company does with its earnings.

The first option is to increase the dividend, or to start one if the company has not paid one in the past. Investors generally like a dividend increase, because it puts money directly into their pockets to be spent, reinvested in the same stock or invested another way.