Ask someone what the most important factors in determining if a publicly traded company is a good purchase and many will say it is earnings per share and price-to-earnings ratio. While these two factors are important in determining if a company is good, earnings are only the top layer that has to be peeled away to determine if a company’s stock is a good purchase.
I was one that fell into this category. I have always dabbled a bit with the purchasing of stocks. When doing my homework on what to buy or pass over, it always started with what are the earnings per share and what is the ratio to price. I could never figure out why someone would pay $30 for a share of a pharmaceutical company that had negative earnings of .10 per share. Today as a student who has just decided to go back to school for my MBA, I am taking my first accounting class. I have seen in just a few short weeks that there is much more to buying a stock than earnings alone.
We know that earnings are the sales minus the expenses over a given period of time, which is usually looked at over a three-month or one-year period. Without any earnings, we can almost right off any company as a bad investment. Now, I say almost any company because after reading about assets, liabilities, and owners equity on countless balance sheets, a light bulb went off in my head. While these documents provide a great deal of information, they only give hard numbers and can not tell the entire story of a company. The reason someone would pay $30 for a company losing .10 per share is based on potential future earnings. If a pharmaceutical company has a drug in its pipeline that could potentially increase sales by millions for that company then investors are willing to take a risk based on the potential of future earnings.
When looking at companies stocks and there comparative balance sheets, it becomes evident that how much factor it has on the price per share is very sector specific. If you take a look a companies that are well established in industrial equipment and financial sectors the price to earnings are all within a moderate range. From looking at the balance sheets, the difference in the stock prices in these sectors can easily be explained by looking at the basic line items over the last three years: assets, liabilities, and shareholder’s equity. This equates to the basic equation that needs to be driven home to understand the balance sheet: Assets= Liabilities + Owner Equity.
This all seems easy enough until we start looking in to some other sectors when the stock pricing gets complicated. When you start digging into the Drug provided and Internet information provider sectors, the ties of stock price to the balance sheet goes out the window. Looking at the Internet information companies we see an example of a company that has yet to release a balance sheet and earnings of only .19 a share trading at 100 times earnings. Conversely we see a company that is well established that earns over $3 a share and only trades at five times earnings. There has to be reasons for this that go deeper than the numbers. The reasons can be attributed to potential future earnings, diversity of revenue streams and, to some extent, simply what is popular at the time.
All in all while earnings are what drive a company, they alone can not make a company a good one. The balance sheet, income statement, and cash flow all provide valuable knowledge to the potential investor deciding weather or not to purchase a stock. It is essential that when doing homework on a company to look deeper than the hard numbers to determine if the investment can be deemed a good one.