Just how important are a company's earnings?
Our ratings system consists of 12 factors, for a total of 13 points. That means one factor is worth twice as many as all the rest. Which one? Current earnings. Yes, our ratings system values a company's current net income as the most important factor, in many respects. Now, you may be thinking: but there is so much more to a company than its earnings. You'd be absolutely right, and that's why there are 11 other factors (one of which is long-term earnings trend). But, allow us to explain the method to our madness.
Making Dollars with Pennies outlines the significance of a company's current earnings:
- The very reason for a corporations existence is to make a profit;
- Current earnings can indicate future prospects; and
- The price of a company's stock reflects current earnings.
Let's break down each point.
1. The very reason for a corporations existence is to make a profit
A company's goal is to MAKE MONEY (unless it's a non-profit, but that's a different story). When a company is making money, it's called a profit or gain. When a company is losing money, it's called a loss. Turning a profit strengthens a company by bolstering its assets.
2. Current earnings can indicate future prospects
With bolstered assets, a company has the means to expand and grow. Ideally, expansion leads to growing profits, allowing for further expansion and growth. If a company is not making money, it's options for expansion are limited; thereby, decreasing its future prospects.
3. The price of a company's stock reflects current earnings
Here is where we, as investors, benefit from increasing profits. There are many ways to valuate a company, one of which is its earnings per share (EPS). This is the company's earnings over its number of shares. Simply put, if a company makes $1 million and has 10 million shares outstanding, its EPS value is $0.10. This value provides a means for comparison amongst similar companies operating within the same industry. It also shows a stock's value over time. How? If a company's EPS is going up, the company's shares are becoming more valuable; going down, less valuable. As shareholders, we want our shares to increase in value so their price appreciates.
How do we determine what good current earnings are?
In order to receive a check in the current earnings column of the Bowser Ratings System, a company must show year-over-year quarterly growth. So, if company XYZ posts a $1.3 million net income in its most recent quarter versus $1.0 million for the same period last year, it receives 2 points towards the possible 13. Another example is a company that reports a $0.5 million loss versus a $1 million loss one year ago. Despite the company losing money, it receives 2 points because its earnings were up (smaller loss).
Often, we omit one-time charges because they don't necessarily illustrate exactly how a company is doing. In cases where they could hinder a company's future performance, we consider them. But, for the most part huge gains/losses from discontinued operations or litigation settlements, etc. are not considered.
As with many factors, the expectations for Companies of the Month are greater. Except in EXTREMELY special and rare cases, a company MUST be profitable in order to be considered for Company of the Month. Why? We like to see the company making money for the reasons above. Otherwise, its prospects are harder to determine and its future is more uncertain. In short, the stock is more speculative.
Tying it together, as an investor, you should ALWAYS consider current earnings. After all, if the company's earnings are steadily dropping, why would you invest? We want to see earnings growth and profitability. That way, our holdings become more valuable, and our portfolio's value grows.
The Bowser Report is a monthly financial newsletter that specializes in small stocks trading for $3/share or less. Our goal is to provide the individual investor with relevant information on microcap stocks. Each month, we recommend a new company, provide information on past recommendations and report news surrounding the microcap marketplace.
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Information in this blog post contains references to past Bowser recommendations. This blog post contains no recommendations, and instead relies on data gathered on past recommendations from sources thought to be reliable.
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