What is Earnings Power?

Felicia Dye

The degree to which a business is able to generate profits is known as its earnings power. Investors use earnings power as a tool to help determine whether they should put their money in a particular company's stock or not. The same methods of assessment are not always used, even when they are conducted by the same investors. Although it is not mandatory, earnings power is often based on annual figures. A company's financial statement is usually heavily relied upon for such assessments.

Man climbing a rope
Man climbing a rope

A company's earning ability and its stock potential are often related in a positive manner. This is logical because, generally, when a company makes more money, stockholders have the possibility of making more money. For this reason, investors tend to use various methods to assess a company's ability to be profitable before risking their money.

There are several ways that a company may earn money. Return on assets (ROA) and return on equity (ROE) are two measures commonly used to determine earnings power. ROA is the ability to earn money from the items that a business owns, but this measurement does not take into consideration all of the necessary expenditures. The other method, ROE, assesses how well a company can get returns from net assets, which is the amount that remains once debts have been settled.

These figures alone may give an investor some idea about earnings power, but they are usually put into further perspective. Both ROA and ROE make assessments within a certain frame of time. Once the current figures are attained, it is common for investors to compare them with previous figures for similar time periods. For example, the ROA for this month is likely to prove to be a more effective indicator if it is weighed against the ROA for the past 12 months to determine whether earnings are increasing or declining.

Despite the fact that these two measures are common, there typically is no overall and conclusive best method to determine a company's earnings power. Several measures may be needed when assessing a single business and those may not be the best choices for assessing another. What one investor views as positive, another may view oppositely. Long-term, moderate-to-high earnings is regarded as a good indicator for many investors. Some, however, may be enticed by short-term, very high return stocks because they may be able to reach financial goals more quickly.

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