The most important metric to consider when considering a stock price's future direction is the growth rate of earnings. From a big picture, it's certainly valuable to consider How Much Money a company earns over a period of time, but more important is at what rate the earnings of the company are growing. This is more important than the valuation of a stock, what they actually make or do (although that is important as well to consider where we are in history, technology, science, or any other industry you feel as a potential investor will reflect the future), and certainly more important than the stock price itself. The stock price, whether it is a big number, or a small number, has been the most misunderstood, yet the simplest concept, I have seen by people who have not experienced very much investing in the past. Despite explaining what a stock price means to friends, family, and clients, I am always a bit confounded as to why, after explaining it, people seem to continue to misunderstand it. But stock price, and what it means, is for another post.
Earnings, or Earnings Per Share (EPS), represent the profit of a company. The Earnings are the absolute number, like $50 million. The EPS is simply the Earnings / Shares Outstanding. It's a way to represent the profit in relation to 1 share of stock (equity).
So with $50 million in annual earnings and 25 million shares outstanding, the EPS is $2. If next year the EPS will be $3, the earnings have increased by 50%, (3-2) / 2. That number is the growth of earnings, or how fast a company is growing. This is the number which I believe is the most important number to consider, of hundreds of other considerations.
A company that is growing their earnings at 50% per year, will reflect a better investment opportunity in that company's stock, everything else held constant. It doesn't mean it will actually outperform the other stock, but there's a better chance of that happening, than another metric we observe changing.
The profit of a company is equal to the overall Sales, or Revenue of that company (all the sales without considering any costs of running the company) minus the overall Expenses of the company. Profit = Sales - Expenses. How much of the Earnings a company decides to keep or retain or invest back into the company is called Retained Earnings. Retained Earnings directly increases the Equity in the company. So, another way to consider this, or an additional element of understanding Earnings and how it affects stock price (in addition to whether earnings are increasing or decreasing over a period of time) is to consider how much of the profit or earnings are retained inside the company, thereby increasing the equity of the company.
There are many metrics to consider when considering whether to invest in a company. Earnings growth is the most reliable metric. When a company is growing at 50% per year, theoretically, the stock will grow at a similar rate, in order for the valuation (Price/Earnings) P/E to stay constant.
For example, consider the case above with the stock that has earnings growth of 50% from one year to the next, and consider that this has been the case for the last several years - that's pretty smooth earnings growth. If the Price of the stock is currently at $200, and EPS is $2, that defines the P/E, Price-Earnings Ratio at $200/2 this year, which is 100 P/E. If that valuation of 100 P/E stays constant, then if Earnings grow 50% next year, the price of the stock needs to also grow at 50%, to keep the P/E at 100. In this case, the math is: $200*(1.5) / $2*(1.5) = 300/3 = 100 P/E. In contrast, if the stock grows at 100% from this year to next, and the earnings only grow by 50%, what happens to the P/E.? ($200*2) / ($2*1.5) = $400 / 3.5 = P/E = 114. The P/E, or valuation has increased from 100 to 114, making the stock more expensive relative to its profit or earnings. The stock price has increased faster than the 12 month trailing earnings (the earnings for the past 12 months).
Another related consideration, and some might argue a more important consideration than 12 month trailing earnings, is the forecasted next 12 months of earnings, because the stock market is a leading indicator of the future, or expectations about the future is what really drive the stock market.
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