Earning Power

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21 Aug, 2024

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Earning Power refers to the profits a company is able to make over a period from its business operations, i.e., the sale of goods or services. The ratio of a corporation's Earnings Before Interest and Taxes (EBIT) to the business's total assets indicates its ability to generate revenue and profit in monetary terms.

The earning power of total investment reflects an organization’s efficiency in utilizing its assets for income generation. It helps investors and stakeholders compare two or more companies based on their earning potential. Lenders use this information to assess a company’s financial position before sanctioning loans.

Earning Power Definition

The earning power of a company is a financial performance indicator that analyzes its efficiency to reap profits from its regular business operations.
It is determined by dividing a firm's earnings before interest and taxes by its total assets, i.e., EBIT/Total Assets.
The various earning power metrics include the Earnings Before Interest and Taxes (EBIT), Return on Assets (ROA), Return on Equity (ROE), dividend yield, and Basic Earning Power (BEP) ratio.
It enables investors to compare the financial performance and growth potential of various companies operating in an industry. Also, it helps lenders and creditors gauge a firm's financial health.

Earning Power Explained

Earning Power is a company’s capacity and capability to produce revenue, earn income, and post profits during the course of its operations. Investors, shareholders, creditors, and other stakeholders consider a company's earning potential based on its operating income and total assets.

They also analyze its financial health by studying upward and downward trends within the company that affect its earning capacity and direction. It serves as a basis for their investment or credit decisions. Moreover, a company's earning potential decides the earning power of its stocks since profits are distributed as dividends. It enhances a company’s share price.

It is important to note that the earning power of total investment is not the same as the earning power value (EPV). While the former determines an entity’s profit-making potential, the latter is a stock valuation technique that emphasizes the company's current cost of capital. EPV considers goodwill and intangible assets. What this means is that metrics like the EPV show how profitable a company is or will be in the long term. Economic value added (EVA), which measures a company’s economic performance, is another indicator of long-term profitability and performance.

Certain performance metrics, like the net profit margin, earnings per share (EPS), etc., measure how profitable a company is in the existing conditions. Hence, when investors contemplate investing in a company, they must consider both indicators—those that show short-term, immediate, or current performance and the ones that indicate an entity’s long-term prospects.

By computing the earning power figure, companies can streamline various functions and activities, including budgeting, demand, and sales forecasting, marketing, operations management, and benchmarking, among other things.

While we have discussed the earning power of companies here, this concept applies to individuals, too. For individuals, education, skills, field, industry, geographical location, experience, etc., contribute to their earning potential—both present and future. Also, earnings from investment, house property, rental property, mutual funds, insurance, other financial products, etc., contribute to an individual’s income.

Metrics

An enterprise's performance can be examined through the following parameters.

Earnings Before Interest and Taxes (EBIT): The earnings before interest and taxes figure shows a firm's profits derived from its business operations before interest and taxes. To calculate the EBIT figure, one must subtract the cost of goods sold from total revenue to get the gross profit. Once this figure is calculated, operating expenses are subtracted from it.
Return on Equity (ROE): The ROE metric evaluates a firm's financial performance in terms of its profitability compared to its equity shareholders' investment. It is the ratio of a business's net income to its shareholders' equity.
Return on Assets (ROA): This measure ascertains a company's potential to utilize its assets for generating income. It is computed as the ratio of a business's net income to its total assets in a given period.
Dividend Yield: As the term suggests, a company allocates dividends in relation to its share price. It is one of the critical measures investors consider while determining the future returns of potential stocks. It is computed as a ratio of annual dividends to the company's stock or share price.
Basic Earning Power (BEP) Ratio: One of the key determinants of business performance is the basic earning power formula that shows the ratio of operating income or EBIT to a firm's total assets. If a company has a high BEP ratio, it means that the business employs its assets efficiently for income generation.

Examples

Let us dive into a few examples to understand the need to analyze the earning power of companies.

Example #1

Suppose an investor, Caitlyn, wants to invest in the stocks of insurance companies. She is considering two insurance companies, Atlas Valor Insurance and Beacon Rockwell, for investment. Caitlyn has enough funds to invest in the stocks of only one company. She goes through the financial statements of these companies and evaluates their EBIT, Basic Earning Power (BEP) ratio, and ROE.

Metrics	Atlas Valor Insurance	Beacon Rockwell
EBIT	$27,850	$32,740
BEP Ratio	12.64%	11.90%
ROE	0.22	0.15

On analyzing the above metrics, she saw that though Beacon Rockwell is generating a higher EBIT, Atlas Valor Insurance has more potential since it has a better BEP ratio and ROE. Therefore, she finds Atlas Valor Insurance’s stocks more attractive for investment compared to Beacon Rockwell’s.

Example #2

According to a December 2023 report, ExxonMobil is on its path to improving its earning power in the near future. The company’s focused strategies since 2019 have brought about a $10 billion increase in its annual earnings. It is expected to post a growth figure of $14 billion between 2023 and 2027.

The company aims to achieve $6 billion in structural cost reductions by 2027. Its upstream earnings are expected to double by 2027, driven by low-cost projects and a potential reduction in the emission intensity of greenhouse gases.

Also, the corporation predicts oil and gas production to reach 4.2 million Barrels of Oil Equivalent Per Day (boe/d) by 2027. Moreover, the various product solution plans designed by its team are expected to boost its earnings by nearly three times through cost reductions and strategic projects by 2027.

The company's capital expenditures are forecasted at $23-25 billion in 2024 and $22-27 billion yearly from 2025-2027. Over 90% of its projects are planned with payback periods of under 10 years. The company’s plan to repurchase shares worth $17.5 billion in 2023 is expected to offer specific advantages, starting with an increase of $20 billion annually from 2024.

ExxonMobil is investing over $20 billion in low-carbon solutions by 2027, focusing on lithium, hydrogen, biofuels, and carbon capture. Acknowledging unknown variables across its energy transition operations, ExxonMobil plans to roll out emissions-reduction investments in phases while working towards net-zero emissions by 2035.

This illustration offers a comprehensive picture of how a company can offer helpful business input to its stakeholders, helping them make crucial investments and other economic decisions.

How To Increase?

In the present scenario of cut-throat competition, increasing a company's earning power can be challenging. However, businesses can adopt the following strategies to enhance their profitability.

Market Expansion: Companies can penetrate new markets to capture new business opportunities, introduce new products and services, and grow revenue streams.
Cost Reduction: Another way is to curtail the cost of production further by reducing waste, streamlining operations, limiting labor idle time, and negotiating with suppliers.
Automation: Improving process efficiency and productivity is possible by automating difficult and time-consuming tasks, reducing overall costs while optimizing output.
Budgeting: It helps companies plan and track their cash inflows and outflows to attain operational efficiency. This includes implementing effective internal controls to curb unnecessary expenditures and potential mismanagement.
Capital Investment: Business entities can maximize their long-term returns by investing capital in assets or projects that have the potential to generate high profits in the future.
Improving Productivity: When companies scale their production to meet the rising market demand, they may be able to bring down the per unit cost while increasing sales. Hence, bulk production and economies of scale can do wonders for businesses.
Product Innovation: Investing in technology and innovation increases the sales prospects of the company's products or services by attracting new customers and boosting customer satisfaction.
Marketing and Sales Efforts: One of the direct ways of multiplying profits is by enhancing a company's visibility and reach through effective marketing and sales strategies.
Better Vendor Relations: Strengthening supplier relationships can help the firm offer higher discounts and favorable credit terms, which indirectly improves its operational efficiency and profitability.
Analytics: By developing systems to gain operations-related insights, companies can modify, restructure, or replace business processes and strategies for improved performance.

It must be noted that boosting company earnings requires a focused approach, keeping in mind that all connected or relevant stakeholders must be on board with management’s plans to derive the best or most optimum results.

Advantages And Disadvantages

The earning power of companies acts as a mirror of their financial performance and growth potential. Let us discuss the benefits and limitations it brings to business.

Advantages:

Determines Financial Stability: A higher earning power indicates sound financial health or position of a company.
Facilitates Comparison: It enables investors and shareholders to compare companies within a particular industry based on their financial performance to make investment decisions.
Attracts Investors: Firms can drive in more investments with a strong earning power ratio. Companies can even present business or market outlook reports from time to time to gain investor buy-in.
Facilitates Borrowings: When a business showcases a high earning potential, suppliers, creditors, and lenders assume that the risks associated with extending credit to such companies are low. Hence, such companies can secure favorable credit terms.
Analyzes Operational Performance: These metrics estimate core operational efficiency without considering other factors that dilute the results (like debt expenses, taxes, etc.).
Gauges Asset Utilization Efficiency: The earning power of total investment determines an entity’s ability to employ its assets for profit-making.

Disadvantages:

Limited Insight: Since earning power calculations focus only on a company’s operating income, it fails to provide a broad overview of an enterprise's financial performance, making it challenging to compare businesses at different stages of their life cycle.
Overlooks Debt Aspect: Some companies, especially the ones in the growth phase, may have high debt and increased insolvency risk, which is not considered by such metrics.
Ignores Interest and Taxes: It does not account for interest payments and taxes, which typically fluctuate across different periods, increasing the overall expenses of a business.
Assumes Stable Business Environment: These metrics consider that business conditions and environment remain stable, which is not the case since vendor contracts, labor requirements, etc., usually change from time to time.
Does Not Account for Fluctuations: These measurement parameters ignore internal and external environmental changes, including government regulations, market conditions, and uncertainties that significantly impact business performance.

Frequently Asked Questions (FAQs)

1. What is a good earning power ratio?

An ideal Basic Earning Power (BEP) ratio varies from industry to industry. However, a company should have a higher BEP ratio when compared to its competitors within the same industry to be categorized as efficient. Industry trends, benchmarks, and regulatory changes have multiple and varied implications for businesses.

2. What is the earning power of a person?

The earning power of a person reflects their capability to earn money. Such earnings can be categorized as follows:
• Active Income: Generated from engaging oneself in employment, profession, or business;
• Passive Income: Derived from appreciation of assets owned by an individual; or
• Portfolio Income: Earned from selling a security or investment.

3. How does inflation affect a company’s earning power?

A rise in inflation has a mixed impact on companies' earning power. During such periods, the prices of goods and services surge, enabling businesses to derive higher business profits. Therefore, investors should consider investing in stocks at such times to yield higher dividends or share value appraisal. However, inflation can also have some downsides. For instance, the cost of raw materials might go up during inflationary periods. Similarly, central banks may increase interest rates, which can adversely impact borrowing costs.