Earnings season, is there any other feeling like it? It reminds me of waking up on Christmas morning, dashing downstairs to reach into the Christmas stocking, pulling a grenade pin out.
Maybe you too have experienced a stock that falls flat after a good earnings report that beat the analysts’ expectations.
At times the earnings reports and their effect on stock prices can feel like a mystery, so that’s what we’ll look at today.
When it comes to stocks, one of the key factors determining its price is money. Bread, paper, moolah, loot.
In Sweden there’s a saying, “a dear child has many names.”
And what is dearer to investors than money?
In the long run, stock prices are determined by how well the company can convert sales to cash.
So you would think a good earnings report would have a positive effect on the stock price, and a bad one will have a negative effect. But that’s not always the case.
Earnings Reports effect on Stock Prices
So why is it that a good earnings report can affect a stock’s price negatively and vice versa? If the company turns out to have higher earnings than the analysts estimated, why wouldn’t the stock price rise?
The answer is quite simple, and also explains why it can be so hard to predict how an earnings report will affect prices. The answer is: Expectations.
It doesn’t matter how good an earnings report is if the market expected it to be better. If earnings increased by 15% but the market expected a 30% increase, the stock’s price will most likely decline even if it was a good report.
At the same time, it doesn’t matter how bad an earnings report is if the market expected it to be worse. A stock can rise on a 15% decline in earnings if the market expected a 30% decline.
And that is also why paying attention to prices is so important, because it’s in the stock price that the expectations lie.
This might come as a shock to some people, but just because you’re sure that a company has an excellent future ahead of itself, it doesn’t automatically mean that the stock is a good investment.
The reason is, as you now know, expectations. If it’s likely that a company will grow its earnings at a fast rate, the expectations are high, and the result of high expectations is most often a high stock price.
And when good earnings are already accounted for in the stock price, a good report will most likely not have a large impact. But on the other hand, if it’s a bad report, it can have catastrophic consequences on the price.
Now that we know how important it is to know about the market’s expectations, we will look at some ways to tell if a stock has high or low expectations.
How to tell if a Stock has High or Low Expectations
To understand how high the expectations are on any given stock, you should look at the price. If a stock has high expectations the price will be high and vice versa. But how can you actually tell if a stock price is high or low?
You can use different value ratios. The most common is the P/E ratio which measures how much you pay for the company’s earnings.
A high P/E ratio usually means that the market expects the company to grow its profits at an above-average rate and a low P/E ratio means that the expectations are low.
If a stock with a P/E ratio of 7 delivers a bad earnings report, no one will be surprised and its effect on the price will probably be small. But if a stock with a P/E ratio of 50 has bad earnings, the price will probably suffer far more.
Here are some other similar ratios you can use to determine if a stock price is high or low:
The importance of paying attention to stock prices can not be overstated, especially when it comes to earnings reports and their effect on prices.
The market’s reaction to an earnings report will differ wildly depending on how expensive the stock is (how much is expected of it.) Let’s look at some statistics on earnings surprises and their effect on prices.
How Surprises in Earnings Affect Stock Prices
In his book, Contrarian Investment Strategies: The Psychological Edge, author David Dreman compares how surprises in earnings affect the price of high and low P/E stocks. What he found might alter the way you choose stocks.
The study took place between 1973 and 2010 and used the 1500 largest companies which were divided into three groups:
- Group A. The 20 percent with the highest P/E ratios.
- Group B. The middle 60 percent.
- Group C: The 20 percent with the lowest P/E ratios.
The surprises were measured against the analyst consensus forecast, the average estimate of the group of analysts following each stock.
So if the average estimate was that the company would have an EPS (earnings per share) of $2 for the quarter and it turned out to have $1.5, this was a negative surprise.
First off, let’s look at how a positive surprise in earnings affected the stock prices. The average return for the period was 3.5% quarterly and 14.8% annually.
Positive Surprises in Earnings
- Group A. The highest P/E stocks returned 4.6% quarterly and 15.4% annually after a positive earnings surprise.
- Group B: The middle P/E stocks returned 4.9% quarterly and 16.5% annually.
- Group C: The lowest P/E stocks returned 6.1% quarterly and 21.5% annually.
As we touched on before, in high P/E stocks, good results are expected and priced in and therefore don’t impact the price much.
But there are no expectations on low P/E stocks and that’s why they outperformed by so much after a positive surprise. Now, let’s look at how negative earnings surprises affected the stock prices.
Negative Surprises in Earnings
Group A. The highest P/E stocks returned 0.4% quarterly and 7.4% annually after a negative earnings surprise.
Group B: The middle P/E stocks returned 1.4% quarterly and 10.2% annually.
Group C: The lowest P/E stocks returned 3.3% quarterly and 16% annually.
Again, an earnings surprise, this time a negative, had a more beneficial impact on the lowest P/E stocks than on the high ones. And again, it’s most likely because of expectations.
Low P/E stocks are expected to perform badly, so when they do, no one is surprised. High P/E stocks are the crème de la crème and investors pay top dollar for their expected superior performance. But when it doesn’t come to pass, the lacking performance has a large impact on the stock price.
So overall, low P/E stocks outperformed the high P/E stocks whether the earnings report was good or bad. I don’t know about you, but I find that information very useful.
In the book, David Dreman then goes on to explain a possible reason for these reactions to surprises. Spoiler alert: it’s not magic, just human nature.
What Causes the Reactions to Bad and Good Earnings Reports
Have you ever heard about dopamine? It’s basically a feel-good chemical released in your brain. Dopamine is what makes you feel happy and motivated, and a flood of dopamine can produce temporary feelings of euphoria.
But what does this have to do with investing?
Well, you see, a high amount of dopamine is released when an outcome is better than you expected. When things turn out as predicted, the dopamine neurons are unaffected. And when the outcome is worse than expected, the neurons are depressed.
This makes a lot of sense when we look at the earnings surprises’ effect on the stock prices.
Because getting what you anticipate produces no dopamine rush, a good earnings report for a high P/E stock doesn’t have any significant impact on the price.
On the other hand, a positive earnings surprise for the unfavored low P/E stocks will likely result in a large hit of dopamine which would translate well when you look at the effect positive surprises had on the stocks.
And negative results are pretty much expected with low P/E stocks, so the dopamine neurons remain as unaffected as the stock prices while high P/E stocks suffer the consequences.
How earnings reports affect the stock’s price largely depends on the market’s expectations.
A “good” earnings report can have a negative effect on prices if the market expected it to be better, and a “bad” report can have a positive effect on prices if the market expected it to be worse.
How much expectation is placed on a stock can be found in its price. If the price is high, there are usually some hefty expectations and vice versa.
To know if a stock price is high, you need to look at some different valuation methods like price-to-earnings, price-to-cash flow, price-to-book value, or price-to-sales. There are also many other methods we won’t go over.
Low P/E stocks have performed better than high ones whether the company reported a positive or negative surprise in earnings which is likely the result of dopamine and its effect on the brain.