Ask Colin

Why does a stock fall in price after announcing good earnings?

The long version of the questions was:

I am wondering if you have any information that can help me understand why some companies' prices fall dramatically the day they announce good profits. I have a small holding in Ammcom Telecommunications and today this is exactly what happened. But this is not the first time I have seen this on the market and I wondered what may be some causes. This may be a great trading opportunity or very important information I need to consider when buying into future stocks. It hasn't affected my holding but I have always wondered why it occurs.

I have not had the opportunity to analyse the Ammcom Telecommunications report, so these comments are not specific to that company, but general in nature.

 

To assess a profit report, we should have an analysis method, comprising the standard financial ratios that examine such things as:

 

Liquidity

Working capital

Capital and debt structure

Profitability

Rates of return

Price compared to value

 

In most cases the above analysis will look not just at the levels of the ratios, but at trends in them.

 

From this we form an opinion about the profit report.

 

Assuming that our judgement is that the report is a good one and the market receives the report badly, we should take another hard look in case there is something we have missed, misunderstood or not appreciated.

 

If our view of the profit report remains positive after careful analysis and thought, we should next reassess our view about the  competitive advantage held by the company to see if there has been some change. A good structure for this is Michael Porter’s SWOT analysis which looks at the Strengths and Weaknesses (internal factors) and Opportunities and Threats (external factors). It may be that the profit report for the last year was good, but the market is perceiving challenges ahead. This analysis requires a very good understanding of the company and its market, but also its competitors and potential competitors, including technological or regulatory disruption.

 

Assuming that our judgement is that everything is fine looking forward and that the stock was appropriately priced prior to the profit report, It may be that the stock was down following the profit report because the whole market or its industry sector were down. In other words, it may not have been a company-specific movement in the price. We should list all its competitors and what happened to their prices in the same period.

 

Assuming that the price decline following the profit report was specific to the company, in other words  it was down and most competitors were not down, The problem may simply be that the market’s expectations for the profit report were higher than ours. So, if the market consensus was that profits would be up 20% (especially if that was the company’s guidance) and they were up only 15%, which you might judge to be a good result, that would be seen by the market as a disappointment, hence the price fell.

 

Assuming there  was nothing on that point either, it may simply be that the market has moved in the short term driven by factors that are unrelated to the profit report. Maybe one or more large shareholders are switching to other opportunities. In other words, it is not just a judgement on the company, but a judgement about opportunity cost. These issues are relative in nature, not absolute.

 

There may also be something that we have not fully appreciated, not picked up on because information is not yet generally available to the market (all insider information is not illegal) or there are more knowledgeable investors who have made better analysis than we have.

 

Above all, once we have done the best analysis we can, we should always bear strongly in mind that markets can be irrational in the short term, even if price tends to mirror earnings in the longer term. There are myriad reasons behind the actions of buyers and sellers. Some may be based on logic and analysis, but many may be more emotional in nature.

 

The bottom line is that if we have an appropriate level of analysis skill and feel sure that the market is wrong, it may be an opportunity.   

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