Understanding Earnings Season

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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.

Companies can also use earnings to buy back shares of their own stock. To use an extreme example, if a company cut its outstanding shares in half, its earnings for each remaining share would double. If the P/E ratio stayed constant, that should double the share price.

Experts have mixed feelings about share buybacks because some companies later issue more shares, effectively reversing the process and diluting the value of each outstanding share. Sometimes buybacks are seen as a way of enriching corporate executives who can then get more by exercising stock options. Buybacks are also sometimes seen as an acknowledgement the company can’t think of anything better to do with its earnings.

The third option is to use earnings for research and development, to acquire other companies or to expand facilities. If things work out, these investments will make the company even more profitable, driving the share price up. Investors have to evaluate the wisdom of this approach on a case-by-case basis.

Finally, the company can use earnings to build up a cash reserve. This can be good for shareholders if it means the company is preparing to pounce on opportunities, but it’s not so good if it means management just doesn’t know what to do with the money. Among American corporations, cash reserves now equal more than 6% of company assets, the highest level since the 1960s, according to The New York Times.

Some experts see this as a good sign, with companies gearing up for expansion once they’re convinced the economic future looks bright. Others aren’t so sure, thinking pessimistic executives are building rainy-day funds. In a few months, perhaps, we’ll know which camp is right.

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