What is the meaning of earnings power?
If we can name the people who have a significant say on buying and selling recommendations, they should be equity analysts. Their words make a substantial impact when assessing a company’s earning power and whether its stocks are worth the investment or not. Of course, they are not called analysts for no reason. Their assessments are always based on facts. However, what is the meaning of earnings power? Earnings power refers to something that shows us a company’s capability to make profits in the long run. This is with the assumption that the company can maintain all current operational conditions.
This is the basic earning power formula, also known as the basic earning power ratio, which we can use:
BEP = EBIT/ Total Assets
Where:
BEP= Basic earning power
EBIT= Earnings before interests and taxes
Tell me more about earnings power.
There are many things that we should consider before coming up with an earnings power. Some of the things that we refer to include the total assets of a company, its latest growth or loss trends, and more. And since we are here, let us list down some of the metrics that we consider relative to earnings power:
- Return on assets or ROA. This refers to a company’s ability to make a profit using its assets.
- Return on equity or ROE. It gauges the financial performance of a stock.
- Dividend yields. Some companies also use dividend yields relative to specific securities when they want to determine earnings power.
What does earnings power have to do with a company’s health?
There is a calculation involved if you want to know the earnings power, called EBIT. EBIT means earnings before interest and tax. It helps us assess a company’s earning power, and it depends on continuous operations and cash flow. EBIT does not include some or all of the irregular income or expenses. Due to this, EBIT can give us an insight into the liquidity of a company. It tells us whether the company is capable of paying debts or not. Finally, we will also get a glimpse of the company’s financial health status.
Earnings power and metrics
We already mentioned a few of the metrics that we can use to determine a company’s earnings power. Different entities have different preferences when it comes to metrics. These entities prioritize one metric over any other metric. Let us say, for example, blue-chip companies, also known as well-established companies, find dividend yields valuable. However, the same is not valid with start-up companies, even when they are rapidly growing. They tend to invest the profits back into their operations as the development stages carry out.
Metrics can’t do everything.
Let us end today’s topic with some reminders. We know that earnings power comes with an assumption that the company will maintain its current ideal conditions. So, some or all of the internal and external fluctuations that can hurt the production rate are not included. Hence, while earnings power can be helpful, it cannot anticipate everything. We should always remember the fact that the risk of market volatility will always be there. Also, earnings power cannot always anticipate every sudden event and regulatory restrictions that can massively impact the business. We all realize that, especially now that we experience the effects of the COVID-19 pandemic. This unforeseeable event is something that earnings power cannot anticipate.