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Stocks Follow Earnings

It doesn’t matter what age of investor I am talking to — the conversation usually starts the same way. Stocks. Follow. Earnings.

When you hear EARNINGS think PROFITS. When it comes to stocks, good profits usually mean a good stock price.

I start my conversations this way because an old boss of mine used to begin every market update with the same line, “Well…stocks follow earnings…I expect companies will report good (bad) earnings so I expect the market will be good (bad) as well.”

Then he would dig into why he thought earnings would be good or bad and discuss other factors that might move stocks. But at the end he would remind us again that other stuff doesn’t really matter “unless it matters to earnings, because stocks follow earnings.”

Remember, earnings means profits. Companies with good profits make good stocks. Companies with GROWING profits make GREAT stocks! If earnings are growing, then the stock price usually grows too. Look for companies you know and understand and wish you owned. Check to see if they are making money, and if and how quickly the business is growing.

Companies report financial results quarterly, including earnings. Results are made public and executives usually provide a conference call in which they report the results of the previous quarter and discuss the state of the current business.

Here’s how I explain it when I’m teaching kids. I compare the numbers to a lemonade stand. I find grown-ups benefit just as much if not moreso from the comparison.

Earnings = Sales — Expenses

The rules of accounting and taxation make the actual calculation much more complicated than this, but for our purposes, this simple formula will work just fine.

Let’s imagine you and a friend opened a lemonade stand this summer and you and your partner sell $100 worth of lemonade.

That means you have sales or “revenue” of $100.

If you had total expenses for lemons, sugar, and supplies of $40, then you have earnings of $60.

$100 Revenue — $40 Expenses = $60 Earnings

It is much easier to analyze data on a “per share” basis, as every company has a different number of shareholders. It makes it easier to compare data across multiple companies if we use per share numbers, like earnings per share.

To calculate earnings per share, or EPS, simply take total earnings and divide by the numbers of shares.

For your lemonade stand, based on your earnings of $60 and two shareholders (you and your friend), your “earnings per share” would be $30.

Earnings per Share = Total Earnings ÷ Total Shares

$60 earnings ÷ 2 shares = $30 Earnings per Share (EPS).

The more lemonade you sell — the more money your business makes. The more money your business makes — the more it is worth if you sell it. The same is true for your lemonade business as it is for any business.

Stocks represent real businesses. Think of them as REALLY BIG LEMONADE STANDS, then look for the one with BEST lemonade that is selling THE MOST. Look for the lemonade stand with a long line of people that can’t wait to spend their money!

Stocks follow earnings or profits.



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