Earnings Power

What Is Earnings Power?

Earnings power is a figure that telegraphs a business's ability to generate profits over the long haul, assuming all current operational conditions generally remain constant. Equity analysts ritually assess a company’s earning power when issuing buy and sell recommendations to best determine if a company’s stock is worth investing in.

Understanding Earnings Power

Earnings power factors in several elements, including a company’s total assets, plus recent growth or loss trends. Earning power likewise considers metrics such as a company's return on assets (ROA), which is the ability to generate profit from its assets, as well as the return on equity (ROE), which is a measurement of a stock’s financial performance. Furthermore, some companies determine earnings power based on dividend yields associated with specific securities.

Earnings Power Metrics for Determining Current Business Health

A company can cultivate a keen insight into its earnings power by examining earnings before interest and tax (EBIT). This calculation examines a company’s earnings power based on continuous operations, as well as cash flow. By generally excluding any and all irregular income or expenses, EBIT provides a reliable snapshot of a company’s liquidity profile, its ability to meet debt obligations, and its overall health.

Some individual sectors and/or industries place greater importance on particular metrics for calculating earnings than others. Case in point: dividend yield carries more weight with well-established blue-chip companies than it does with rapidly growing startups, which are more apt to reinvest profits back into their operations during development stages.

Limits of Earnings Power Metrics

Earnings power assumes that ideal conditions will continue to surround the business. It does not account for any internal or external fluctuations that may negatively affect rates of production. Therefore, there is an ever-present risk that general market volatility, regulatory restrictions, or other unforeseen events may affect business flows in ways that earnings power cannot anticipate.

The Basics Earning Power Formula

The basic earning power (BEP) formula, which is also referred to as the basic earning power ratio, is as follows:

Basic Earning Power = Earnings Before Interest and Taxes (EBIT)/Total Assets