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How Do Stock Prices Change Based On Earnings Reports?

How Do Stock Prices Change Based On Earnings Reports?

Every quarter, public companies release an earnings report which states how the company performed during the previous quarter. This earnings report indicates the financial strength of the company. It shows how much revenue, profit and operating income is earned and gives an estimation of next quarter’s performance.

Expectations, expectations, expectations..

A couple of weeks before releasing the earnings report, analysts working for big Wall-Street corporations make their estimates of how the company performed during that quarter. They do this so that the big Wall-Street banks can invest in those companies, before everyone else. This way, if it turns out that the company indeed had a good quarter, the Wall-Street banks can make a lot of money.

Revenue Estimates of Alphabet Inc. (former Google Inc.)

Revenue estimates for Alphabet Inc.

Source : Yahoo Finance

These analysts estimates are widely available on the internet weeks before the earnings report is released. Therefore, you, me and all other investors could act based on those analysts estimates and invest in the company because we think we can make a nice profit on it. This extra demand for the stock pushes its price upwards. When this is the case, we say that the expectations of the company’s quarterly performance is already reflected in the stock price (which is also called ‘priced in’). This all still happens before the actual earnings report is released. So it’s basically a form of speculation, since we don’t have the actual facts to support our expectations.

Earnings (EPS) Estimate of Alphabet Inc.

Earnings estimate for Alphabet Inc.

Source : Yahoo Finance

When the earnings report is actually released, all investors and Wall-Street analysts will immediately look at the report to see if their expectations of this quarter’s performance are met. If this is the case, usually, the stock price doesn’t really change. Why? Because these expectations were already priced in the stock. It wasn’t a surprise anymore.

Earnings Surprises

But what if the analysts were wrong? We call this ‘earnings surprises’, which can either be a positive or negative surprise. The job of an analysts isn’t easy, because it involves predicting the future. It turns out that humans aren’t really good at predicting the future. Why? Because the future is uncertain. Any random event outside of our control can influence the outcome of our predictions. As you can see in the picture below, analysts aren’t always right, which causes these so called ‘earnings surprises’.

Earnings Surprises for Alphabet Inc.

Earnings surprises for Alphabet Inc.

Source : Yahoo Finance

Positive Earnings Surprises

What if a company performed much better than expected? Then, the stock price is likely to increase because the actual results are higher than the expectations, while the price was based on the expectations.

An example of this positive earnings surprise was Netflix’ Q3 (third quarter) earnings report. Analysts expected an EPS of $0.06 while Netflix earned an EPS of $0.12, which is twice as high as expected! Not only did the EPS turned out to be higher than expected, but also the amount of new subscribers increased more than expected.

What happened to Netflix’ stock price? It gained more than 18% in 1 day!

Netflix gaining 18% in one day after releasing Q3 2016 earnings report

Netflix gains 18% in one day after Q3 Release

Source : Bloomberg

Negative Earnings Surprises

What if a company performed much worse than expected? Then, the stock price is likely to fall because the actual results are lower than the expectations, while the high price was based on the expectations.

An example of such a negative earnings surprise was Abercrombie & Fitch (Ticker : ANF) in August 2016. It’s EPS was estimated to be at -$0.20 (a loss) while it’s actual EPS was -$0.25 (an even bigger loss). Also, Abercrombie & Fitch announced to close more stores than expected. This caused shares of Abercrombie & Fitch to fall by 21% in one day, as you can see in the graph below.

Abercrombie & Fitch (Ticker : ANF) falling 21% at the end of August 2016

Abercrombie & Fitch falling 21%

Source : Bloomberg

Another Way Earnings Affect The Stock Price

Another way that the stock price can change is when the next quarter’s guidance is high. Guidance is that what a company expects to earn in the next quarter.

If this guidance is high, it means the company is confident in its own ability to perform well next quarter. This confidence is what investors like to see, so they invest in shares of the company, which drives the share price upwards.

The other way around, when guidance is low, it shows that the company has a lack of confidence in next quarter’s results. Investors will quickly catch onto this and sell their shares of the company, driving the stock price down.

Why would you want to own shares of a company, if the company itself doesn’t believe it will perform well?

It’s all speculation..

Earnings reports play a major influence in the short-term price movement of a stock. The two major factors that determine if the stock price will go up or down after the earnings release are earnings surprises and earnings guidance. However, anticipating these factors remains speculation, and should be handled with great care.

Personally, I think it is best to base your investment decisions on long-term investing instead of short-term speculation. In a long-term strategy, quarterly earnings releases can be used as buying opportunities for example. Especially if a company fails to meet analysts’ quarterly expectations, while its long-term outlook still looks good.

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