If you are a stock market investor you are probably aware of how volatility can impact your portfolio, and your stocks can drop after earnings. Even if the company had good earnings, it does not prevent the stock price from tumbling.
This can happen for several reasons, but it is usually either attributed to the earnings report or a change in the long-term outlook for the company.
How do earnings affect stock prices?
Earnings are usually a very awaited moment in the stock market. Analysts will use models in order to predict the company’s main financial metrics. Such as revenue, net income, and EPS.
There are usually several analysts covering the same stock, and although they have different predictions and projections, there is usually a consensus among them. This means that their projections for these key financial metrics are calculated as an average.
There are a few combinations of factors that can usually affect stocks after earnings. In order to understand that you need to ask two main questions:
- Did the company beat analyst estimates?
- Are the management estimates higher or lower?
How do earnings affect stock prices after beating analyst estimates?
Beating estimates does not guarantee that the stock price will go up. It is positive news, but it is also in the past. Management may lower its guidance after beating earnings estimates, and this is one of the reasons stocks drop after earnings.
How do earnings affect stock prices after management guidance?
Management might improve or lower its guidance after the earnings results. This is another factor that explains why stocks drop after earnings. If the guidance is improved the stock will tend to go higher. Conversely, if the guidance is lower than previously stated, it is very likely that the stock will drop.
Depending on the company, management might not disclose its guidance. One of the reasons might be to not reveal any information to their competitors.
What can happen after the earnings release?
The two factors that influence the stock price the most after an earnings release are analyst estimates and management guidance. Therefore, there are 8 possible scenarios, based on these two factors.
It should be noted that scenarios 2 and 3 are highly unlikely. A stock beating estimates, and improving its guidance dropping is unlikely.
In the same way that if a stock does not beat estimates and lowers its guidance, the stock price will most likely not go up. However, these are just the main factors that can explain why stocks drop after earnings.
Why do stocks drop after good earnings?
Even if your stock had impressive earnings that beat analyst estimates, that does not ensure that the stock price will go up. The stock market is forward-looking. This means that the value of stocks is determined by their future outlook, and not so much by their latest earnings.
We have seen that earnings estimates and results, along with management guidance are two of the most determining factors for how stock prices behave after earnings. However, there are other factors that can impact stock prices, and explain why stocks drop after good earnings. It also explains why stocks rally even after terrible earnings results.
Other reasons that make stocks drop after earnings:
- Other financial metrics
- Management changes
- Institutional investors
Stocks may drop after impactful news that the market was not aware of. This explains why even if a stock beat earnings and management is improving its guidance, the stock might still drop.
The news may also be bullish, and even with lower guidance and lower earnings, a positive piece of news can make the stock rally.
Although the most anticipated financial metrics in earnings releases are revenues and earnings, analysts also look at other metrics. This means that any significant changes for example in debt or the issuance of debt at unfavorable terms might explain why stocks drop after earnings.
If the management of a particular company is changing, this can have both a positive and negative impact on the stock price. Therefore, it is dependent on how the market consensus perceives the current management.
Usually, if a certain CEO is well-regarded by the market, its departure will explain why the stock dropped. Conversely, a subpar CEO leaving the company can make the stock rally.
A buyback announcement is extremely positive news. As it shows the company has enough liquidity to deploy buying its own stock. Shareholders and investors will also be more willing to continue to invest in the company, knowing that the management is buying at the current stock price.
This also increases their ownership of the business and the earnings per share. Additionally, it might lead to a dividend increase, if the stock pays a dividend.
Most retail investors are not fully aware of the influence large institutional investors may have on a stock price. Consider an example where a certain pension fund wanted to sell a stock in its portfolio.
They might wait for the earnings release to sell their position, and this can explain why stocks drop after earnings even if the earnings were stellar, and with improved guidance from management.