The relationship between a company's earnings and its stock price can be complicated. High profits don't necessarily mean a high stock price, and big losses don't always lead to a low stock price. Of course, without earnings it is hard for companies to stay in business for long. You could say that two of the major factors that influence stock price are current earnings and the promise of future earnings.
Generally speaking, an increase in a company's earnings will also help raise the overall earnings per share value.
Earnings Per Share
The first step in understanding the relationship between the price of a stock and its earnings is to look at its earnings per share, or EPS. The EPS tells you how much income the company generated for each share of stock. For example – and let's assume the company pays no dividends – if a company has $10,000 in earnings, and 1,000 shares, the EPS would be $10,000 divided by 1,000, or $10. You can find a company's quarterly and yearly EPS by looking at the investor relations page on its website or typing in its ticker symbol on most financial websites.
Price to Earnings Ratio
The direct relationship between the price of a stock and its earnings is known as the price per earnings ratio, or P/E. To calculate P/E, simply divide the stock price by the EPS, typically over the most recent four quarters. For example, if the price of a stock is $50 and the EPS are $1, the P/E would be 50. You can find a company's P/E ratio on any financial website. The P/E tells you how much an investor must pay to capture $1 of earnings for a company. According to the Seeking Alpha financial website, the average P/E ratio in the 2000s was 20.2, up from an average of 19.6 in the 1990s.
A high P/E means that investors are paying more to capture $1 of earnings, but also means the market believes the company is capable of significant future growth. It is also important to note that while a company can have negative EPS, it cannot have a negative P/E. If a company has lost money, a P/E cannot be calculated.
Earnings vs. Projections
One way earnings influence the price of the stock is how well a company performs against expectations. Before most companies report their quarterly financial results, analysts predict the EPS for the quarter based on the company's guidance and other factors. It is a common practice to underestimate EPS; if a company beats the projected earnings, its stock price will usually go up.
But if a company fails to reach the projected earnings, its stock price will most likely decline. A company could have a very profitable quarter, but if it makes less than was projected the stock price is likely to fall. Similarly, if a company loses money – but the losses are lower than projected – the stock price is likely to go up.
Impact of Earnings on Stock Price
If a company doesn't produce consistent earnings growth or lower its P/E ratio over time, investors might choose to sell the stock, sending its price lower. Young or growth-oriented companies that have extremely high P/E ratios or lose money might have a high stock price due to projected future growth. But a lack of earnings over a long period of time will usually (but not always) drive a stock price down and the company potentially out of business.
One example of an exception to this rule is Amazon. Amazon, in June of 2014, had a P/E ratio of 511.06, and a stock price of $334.48 per share. This P/E may seem high, meaning the stock could be overvalued, however, in the case of Amazon, the company drastically cut profit in order to expand operations. Using P/E, in this instance, as the sole indicator of whether or not you should have bought the stock, would not have given you a reasonable idea of its value.
Based in Chicago, Charles Grant has been writing about money since 2005. He also serves as a financial manager and consultant. Grant received his Bachelor of Science in finance from the University of Illinois at Chicago.