Earnings is a pretty simple concept: you get revenue, subtract expenses, and get earnings. But there are many different types of earnings, all derived from different ways of subtracting expenses. Operating income, for instance, is when you subtract COGS and operating expenses to revenue. This way, you ignore the impact of taxes, costs related to research and development, fixed costs such as real estate and property, and the cost of debt. You would want to exclude all of these things to see if the business is feasible in the long term, ignoring short-term hits due to the large costs that are involved in initially setting up a business. Operating income is sometimes considered EBIT (earnings before income and taxes)
This differs from EBITDA, earnings per share, and other metrics, which have a different function. EBITDA, or earnings before interest, tax, depreciation, and amortiziation, is similar to operating income but includes the values of amortization and depreciation to give a clearer sense of the long-term operational viability of a company, since the costs of depreciation and amortization are typically front-loaded and have little bearing on the long-term viability of a business model.
These aren’t the only flavors of earnings out there, of course. Earnings per share (EPS) is perhaps the best known, in which net earnings after preferred stock dividends is allocated to each common stock. This will include taxes, depreciation, amortization, and interest expenses, meaning it takes into account all expenses and debts to a company. For this reason, EPS can be unreliable for growth companies, and many analysts will simply ignore it when looking at a fast-growing, especially young or recently restructured firm.
And there are still more measurements. Funds from operation (FFO) is popular among real estate companies such as REITs, which calculates net income and adds back depreciation and amortization (not unlike EBITDA) and then subtracts gains on sales of property (since this is irrelevant to the core operating income of the real estate’s business of renting property). REITs will go further and use adjusted FFO (AFFO), which subtracts capitalized and amortized recurring expenditures. The purpose of this is to take account of REITs’ need to maintain properties through capital expenditures such as repairs or maintenance to existing properties. AFFO is the primary metric used in determining REITs’ profitability, while FFO is used elsewhere in some special situations.
How do you know which earnings metric to use? It depends in part on what asset you are looking at and what you are looking to find. EBIT and EBITDA work best with growth stocks, EPS often is used for value stocks, and FFO/AFFO will work for real estate and some financial services companies. Other earnings metrics may be used in some cases, such as net investment income (NII) or ROIC (return on invested capital), but those metrics are relatively rare and limited in their uses. But any starting analyst should have a deep and familiar knowledge with FFO, AFFO, EPS, EBIT, and EBITDA, since these will be used in the vast majority of investment decisions, both public and private.