Earnings Power

What is ‘Earnings Power’

Earnings power is a business’ ability to generate profit from conducting its operations. It is used to analyze stocks to assess whether the underlying company is worthy of investment. A company’s earnings power is a reflection of the ability to generate income or profits over time, assuming all current operational conditions remain constant.

Explaining ‘Earnings Power’

The total of all assets is often considered in earnings power, along with information regarding recent growth or loss trends. Possessing greater long-term earnings power is one indication a stock may be a good investment. Many metrics are used to solely determine a company’s earnings power. For example, analyzing a company’s return on assets (ROA) and return on equity (ROE) determines the company’s ability to generate profit from its assets and shareholders’ equity, respectively.

Earnings Power Metrics for Determining Current Business Health

A company can gain insight into the earnings power of current operations using a variety of factors. Earnings before interest and tax, referred to as EBIT, is a calculation that examines earnings power of a company based on continuous operations, and is often related to the company’s cash flow. It is based on figures taken before the payment of any interest or tax payments, and generally excludes any irregular income or expenses. EBIT provides an overview of the funds a company has at its disposal to meet any acquired debt obligations, and provides a metric to measure overall business health.

Limits of Earnings Power Metrics

Earnings power is based on the idea the conditions surrounding business operations remain constant and in an ideal state. It does not account for any fluctuations, either internally or externally, that may affect the rate of production in any way. These risks can stem from changes within the particular market in which the company operates, changes in associated regulatory requirements, or other unforeseen events that impact the flow of business in either a positive or negative way.

Further Reading