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Module 2 · Market Instruments · Lesson 5
The single number that drives long-term stock prices.
Quick Answer
Earnings are the profit a company has left after paying its expenses, interest and taxes. Investors use earnings to judge whether a business is genuinely making money and becoming more profitable over time. The main figures to check are earnings per share, earnings growth, operating margin, the P/E ratio and free cash flow. For the underlying maths, our valuation and ratios visual lessons take it step by step.
In the short run, stock prices move on narratives, fear, and noise. In the long run, almost nothing matters except one thing: earnings. Earnings simply means net profit the money left over after a company pays its expenses, taxes, and costs. If a company’s earnings double over a decade, its stock will almost always follow. If a company’s earnings stagnate or fall, no marketing campaign, CEO charisma, or sector hype will save its share price.
Earnings — also called net income, net profit, or “the bottom line” — represent what remains after a company pays all its costs, taxes, and interest. They are the cash the business actually generated for its owners. Revenue is impressive. Earnings are real. A business with $100 billion in revenue and zero earnings is selling more than it costs to make. A business with $5 billion in revenue and $1 billion in earnings is twenty times healthier financially.
This lesson is the practical guide to reading earnings. Five metrics. One real case study. The traps that fool beginners. By the end you will be able to glance at a company and answer the only question that matters in the long run: is this business actually making money, and is it making more of it every year?
The price wobbles. The earnings climb. Over decades, the price has no choice but to follow. Investors who track earnings rather than prices get clarity on what they actually own. Investors who track prices get noise, anxiety, and the urge to trade.
Sources. Robert Shiller CAPE data. Apple 10-K filings. Berkshire Hathaway shareholder letters. May 2026.
Part One
Earnings show how much profit a company reports. Investors care about earnings because long term stock prices usually need long term profits to support them.
If revenue grows 20 percent but earnings are flat, costs may be rising. If earnings grow faster than revenue, margins may be improving.
Looking only at the headline EPS number without checking revenue, margins, cash flow and management guidance.
For one company, compare revenue growth, operating income growth and free cash flow growth.
Earnings Per Share (EPS)
Formula. EPS = Net Profit ÷ Total Outstanding Shares. If a company earns $1 billion and has 500 million shares, EPS is $2. EPS lets you compare profit on a per-share basis across companies of different sizes and across years.
What to watch. Growing EPS is the cleanest signal of a healthy business. Falling or volatile EPS is a warning. Always check diluted EPS too — it includes potential new shares from stock options and convertibles, and is usually lower than basic EPS.
P/E Ratio
Formula. P/E = Share Price ÷ EPS. A P/E of 20 means investors are paying $20 today for every $1 of current annual profit. It is the most-quoted valuation metric in investing.
Rules of thumb. P/E of 5–15 is considered cheap; 15–25 is reasonable for a stable business; over 25 implies high growth expectations baked into the price. Buffett’s value-investing sweet spot historically sat in the 5–15 range. Compare to industry averages — software trades at higher P/Es than supermarkets, and that is fine.
Earnings Growth Rate
Formula. Year-on-year growth rate: (Current Year EPS − Prior Year EPS) ÷ Prior Year EPS × 100. If EPS goes from $4 to $5, that is 25 percent growth. Track this over 5 to 10 years to spot trends rather than one-off quarters.
What to watch. Steady 10–15 percent annual growth over a decade is far more valuable than a single 50 percent jump. Consistency compounds. Look for businesses where every year’s earnings exceed the previous year’s, not just the average.
Operating Margin
Formula. Operating Margin = Operating Income ÷ Revenue × 100. A 25 percent margin means the company keeps $0.25 of every dollar in sales as operating profit. High and stable margins are the signature of strong businesses with pricing power.
What to watch. Margins above 20 percent often indicate competitive advantage — pricing power, scale, or brand loyalty. Margins under 5 percent suggest a brutal commodity business with little room for error. Compare to industry averages; airlines run 5 percent, software can hit 40 percent.
Free Cash Flow
Formula. FCF = Operating Cash Flow − Capital Expenditures. Earnings can be massaged through accounting choices. Cash flow is harder to fake — it is the actual money moving in and out. If reported earnings keep rising but FCF stagnates, look closely.
What to watch. The best businesses generate FCF that exceeds reported earnings consistently. The worst businesses generate accounting profits but burn cash. Enron reported strong earnings for years while bleeding cash. The cash flow statement told the truth long before the share price did.
“Your goal as an investor should be to purchase, at a rational price, a part-interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now.”
— Warren Buffett
Part Two
Case Study
Source. Apple 10-K filings 2005–2024. Adjusted for stock splits.
The point is not that Apple was a uniquely good company. The point is that the share price tracked the earnings. As EPS multiplied 65× over 20 years, the share price multiplied roughly 330× — partly from earnings growth, partly from investor enthusiasm raising the P/E ratio. Investors who tracked Apple’s quarterly earnings and held through volatility were rewarded. Investors who tracked the daily share price and panicked during the 2018 and 2022 drawdowns missed most of the gain. Our earnings calendar shows who reports and when.
“If you can follow only one bit of data, follow the earnings. Earnings make or break an investment in equities.”
— Peter Lynch
Part Three
Step 1
Find the 10-K online
Step 2
Check EPS trend
Step 3
Compare margins
Step 4
Check cash flow vs profit
Step 5
Calculate P/E
Part Four
“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
Investor Wisdom
Ten quotes on profit, patience, and the long arithmetic of compounding.
Means. Future earnings are the only thing that justifies a stock price. Focus there.
Apply. Before buying, write down your estimate of EPS in 5 and 10 years. If you can’t, you don’t understand the business.
“If you can follow only one bit of data, follow the earnings.”
Means. Of all the data points, earnings are the most predictive of long-term returns.
Apply. Open the earnings page before the price page every time you check a stock.
“Everyone has the idea of owning good companies. The problem is that they have high prices in relation to assets and earnings.”
— Charlie Munger
Means. A great business at a stupid price is a bad investment. Always check what you’re paying per dollar of earnings.
Apply. Use P/E as your price sanity check.
“In the short run, the market is a voting machine. In the long run, it is a weighing machine.”
— Benjamin Graham
Means. Sentiment drives daily prices. Earnings drive decade prices.
Apply. Hold five years before judging a buy. Earnings need time to play out.
“Cash is a fact. Profit is an opinion.”
— Alfred Rappaport
Means. Reported profit can be shaped by accounting. Cash flow cannot lie as easily.
Apply. Whenever earnings rise sharply, check cash flow alongside.
“The function of economic forecasting is to make astrology look respectable.”
— John Kenneth Galbraith
Means. Macro forecasts are mostly noise. Company-level earnings analysis is the real edge.
Apply. Spend your research time on company filings, not on market predictions.
“The biggest secret in investing is that there is no secret. You just have to find businesses with growing earnings and pay reasonable prices.”
— Peter Lynch (paraphrased)
Means. Investing isn’t mysterious. Growing earnings + reasonable price = good return over time.
Apply. If a stock fails either test, skip it. Both must be present.
“The investor of today does not profit from yesterday’s growth.”
Means. Past earnings tell you what was. Future earnings tell you what you’ll get.
Apply. Use history to inform forecasts, but pay only for future cash flows.
“Behind every stock is a company. Find out what it’s doing.”
Means. The ticker is shorthand for an operating business. Look through the symbol.
Apply. Read the 10-K before buying. The chart is not the company.
“Time is the friend of the wonderful company, the enemy of the mediocre.”
Means. Quality businesses get better with time; weak ones decay. Hold the right ones longer.
Apply. If earnings are reliably growing, give the position more rope, not less.
Key Takeaways
Five Commitments
Read each one. If you cannot honestly commit to it, the lesson is not finished.
End of Lesson
Module 2 . Lesson 5 of 21 . Continue to Lesson 6 . Debt.
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