The single most important piece of information about a stock is earnings. You hear it on the news all the time now. “XYZ company was up 20% today as they reported strong earnings”. But why is this important? Just because they sold a bunch of widgets last quarter doesn’t mean they will do it again this quarter. And in fact it may be that they offered a great deal on their widgets and everybody is stocked up to the rafters and won’t sell any this quarter. So past earnings don’t necessarily tell us about future demand.
Most analysts will tell you that a string of successfully good earnings reports bodes well for future earnings. And here is where we get the clue as to why earnings do matter. Earnings don’t necessarily tell us about product demand, or about where we are in the economic cycle. But if the company has had ongoing success in making profits, it’s an indication of the quality of the management of the company.
Think about it. How can anyone make a judgement about how good management is at running a company? The best way we can find out is by giving them a ‘test’. And their test is company profits, quarter after quarter.
We can’t know what the economy will do, or how long a product life cycle will last. But if management has had success in up and down markets we can have some confidence in them. And that’s why earnings matter. The trick of course is to buy a stock with consistent good earnings (i.e. good management) but not pay too much.