Earnings season is an exciting time. Stock prices seem to make significant moves around the time companies announce their quarterly earnings. Why? Because there are plenty of people who think they have an idea what those earnings are going to be.
They understand that if the company surprises to the upside, meaning the earnings are higher than what the company or the analysts have predicted, the price of the stock will most likely move higher. If the company disappoints, it’s just what you would expect: a lower price.
This isn’t a hard concept, nor is this a secret by any stretch of the imagination. What I would like to shed some light on is the little-understood issue of why stock prices can drop after a positive earnings surprise.
The standard definition of an earnings surprise is when actual earnings come in higher or lower than the published earnings estimates. These published estimates are generally provided by either the company itself or by analysts from various firms that cover the company.
The problem is that investors tend to develop their own set of estimates or expectations that can differ significantly from the analysts and the company. Sometimes there’s just too much optimism from investors built into the price and the expected earnings of the company ahead of the release. The company would then need to beat its own estimates by a wide margin to appease investors’ inflated expectations.
This is difficult for companies to do, and when the earnings are released, even if they are above the published estimates, it creates selling pressure on the stock. This is a common reason why some stock prices drop after a so-called “earnings beat.”
Another explanation has to do with the quality of the earnings. It is important to understand just how those earnings were generated. Was it through increased sales, meaning that the company’s products are in demand, or through cost cutting or other measures that could be deemed a one-time event? If investors get the impression that the earnings aren’t sustainable, no matter how great they are now, they'll be looking for the exit.
The single biggest reason that prices drop after an earnings beat is when the company provides forward guidance that is not in line with its previous announcements and company leadership openly says things will get tougher in the future. At that point it doesn’t matter how much they beat the estimates by. It’s all about the uncertainty of the future—and investors don’t like uncertainty.
Earnings and estimated future earnings are still considered by most analysts to be an integral part of how to value a value a company’s stock price. Watching the earnings closely and understanding what makes up those earnings can help the average investor make better decisions on when to buy, sell, or hold.
Timothy S. MicKey, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth and @TimothySMickey, and on their Facebook page. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.