Which profits matter most?
Accountants and financial analysts are in an arms race. Accountants try to make a company’s financial statements look not only as accurate as possible but also as flattering for the company as possible. Analysts, meanwhile, try to cut through the noise and focus on the profit measures that really matter. So, which profit measures matter most for the share price of a company?
There are now a myriad of different profit measures, usually referred to by companies and analysts with the moniker ‘adjusted’. Whenever a company reports adjusted profits, you should be wary. Why do they need to deviate from accounting standards? But if we ignore these different variations, we can split profit measures essentially into three categories (I know I am oversimplifying here):
Gross profits and EBITDA, something that at the start of my career in the late 1990s and early 2000s we dubbed ‘profits before all the bad stuff’, but that has become increasingly common as a profit measure that companies focus on.
Operating profits, or earnings before interest and taxes (EBIT). This tries to give the investor an idea of how well the company is doing before the reduction in profits from highly variable cost factors like interest costs and taxes. It is the accountants’ version of stripping out the volatile food and energy prices from inflation data to arrive at core inflation.
Net income or earnings, which is what is left for investors after all the bad stuff happened.
A study from the University of Chicago analysed how investor demand changed in response to companies reporting different profit measures. The chart below shows the sensitivity of institutional investor demand and aggregate market demand (institutional + retail investors) to changes in different profit measures. I find it interesting that the market overall (and hence the share price) clearly focuses on operating profits as the key measure that drives share prices. Meanwhile, institutional investors look at both operating profits and net income. This tells me that operating profits are the key measure that most people focus on, but institutional investors also check net income to get a broader picture of the company’s fortunes that includes interest expenses and other significant cost factors. After all, investors eat net income, not operating profits…
Sensitivity of demand for stocks to different profit measures
Source: McClure and Nikolaev (2025)
However, I would like to add one thing. The study cited here was done with US stocks. In my day job, I once did an analysis of the most important factors that drive share prices in the US, the UK and Europe. For the US stock market, I found that profits are indeed the most important driver of share prices. But in the UK and Europe, I found that share prices react more to changes in past and future earnings growth rather than profitability.
My interpretation of this result is that investors focus on the metric that is relatively scarce in the market. In the US stock market, most companies have decent if not extreme growth, but there are relatively more unprofitable companies in the US than in Europe or the UK (measured as a share of the total number of stocks).
In Europe, profitability is a given, but growth is scarce. So when investors see a company that has strong growth, they are shifting their portfolios to this stock, bidding up its price proportionally more.
As with temperature scales, sometimes the answer is simply "whatever everyone else is using", and I saw over the years that what the big market data providers used for consensus numbers often called the tune. If an analyst showed up at a meeting with portfolio managers and started rambling on about what the *real* earnings number was, eyes start rolling immediately.
My personal observation is that EBIT became the de facto convention because it's the one set of numbers upon which reasonably consistent earnings *growth* numbers can be calculated without entangling capital-structure effects. Back in the 1990s, when a lot of people were still using P/E on EPS as a primary measurement, there was a movement by Silicon Valley companies during the stock-option expensing fight to convince Wall Street analysts to anchor earnings comparisons on EBT. They even had T-shirts printed up to publicize it, but it didn't take, illustrating how hard it is to dislodge a convention once the ecosystem has settled.
P/E is still the starting point in conversations about relative valuation, but as you’ve pointed out, there are so many ‘N/A’ P/Es these days for stocks where investors have already made substantial gains that one can’t be religious about it. I see P/E as the speedometer in a car, while EBIT is more like the tachometer: you can be at zero MPH, but if the engine is revving high at idle, it may signal impending strong forward momentum ... or a looming mechanical problem, something I call “growing yourself broke.”
I also think that sometimes it depends upon in which instruments one is investing. A bond analyst is naturally going to be more interested in whether a company can cover its interest payments than an equity analyst more interested in finding growth. Attempts by accounting standards setters to focus equity people on balance sheet and cash flow statement analysis have largely fizzled out, especially over the past several decades where access to plentiful capital has essentially been a non-issue.
When I came out of school, I thought a financial analyst’s job was to play Sherlock Holmes, uncovering ‘gotcha’ clues others missed. The depressing reality I discovered is that if management is crooked enough to commit massive fraud, they’re crooked enough to find someone to sign off on cooked books.
I did a good course on the valuation of private companies at Oxford last year. One of the things that came from it is how dramatic changes to the capital structure led to an arbitrage if you used P/E ratios as a benchmark for valuation. It is how Mitt Romney made his fortune by taking listed companies private with very high levels of debt.