Earning power is a company’s ability to generate profits, which investors use to decide whether to invest. Return on asset and return on equity are common measures, but there is no conclusive best method. Moderate to high long-term earnings are a good indicator for many investors.
The degree to which a company is able to generate profits is known as its earning power. Investors use the power of earnings as a tool to determine whether or not they should invest their money in a particular company’s stock. The same valuation methods are not always used, even when conducted by the investors themselves. While not mandatory, earning power is often based on annual figures. A company’s financial statements are usually heavily relied upon for such valuations.
A company’s earning power and its shareholder potential are often positively correlated. This makes sense because generally, when a company makes more money, shareholders have the opportunity to make more money. For this reason, investors tend to use various methods to evaluate a company’s ability to be profitable before risking their money.
There are several ways a business can make money. Return on asset (ROA) and return on equity (ROE) are two commonly used measures to determine earning power. ROA is the ability to make money from the items a business owns, but this measurement doesn’t take into account all necessary expenses. The other method, ROE, assesses how well a company can earn returns on equity, which is the amount left over after debts are paid off.
These figures alone can give an investor an idea of earning power, but they are usually put into a larger perspective. Both ROA and ROE make assessments within a certain time frame. Once the current data is reached, it is common for investors to compare it to previous data for similar periods of time. For example, this month’s ROA is likely to be a more effective indicator when compared to the last 12 months’ ROA in determining whether earnings are up or down.
While these two measures are common, there is typically no overall, conclusive best method for determining a company’s earnings power. Several measures may be needed when valuing an individual firm and these may not be the best choices for valuing another. What one investor sees as positive, another may see in the opposite way. Moderate to high long-term earnings are considered a good indicator for many investors. Some, however, may be enticed by short-term stocks with very high yields because they may be able to meet financial goals more quickly.
Smart Asset.
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