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What is a profit warning?

A company often gives guidance to the analysts over what they think the profits are going to be next year, or the year after.

Analysts rely on this information coming out from companies, which is why many analysts talk to chief executives and chief financial officers, to get a gauge as to how the company’s performing.

Only when they have some guidance as to what is going to be happening to the profits can they use those profits, (future profits as well), to discount the future profits back to today, to come up with a valuation for the company.

If a company said, we think we are going to be making 100 million dollars worth of profits next year, analysts can use that figure to try and work out what the share price should be today.

But, if the company then turns around and says, you know how we told you we were going to make $100 million? – well it’s not quite that. We had some pretty awful weather, and so therefore retail sales aren’t as good as we thought they were going to be.  So instead of $100 million, it’s going to be $90 million.

So the company has issued a profit warning, and the analysts then go back, plug the $90 million back into their spreadsheets, to come up with what they think the valuation should be today.

Consequently, when a company has a profit warning, the analysts have to recalculate to think what the company is worth now, and obviously it’ll be lower than what they were previously, and the share price falls.  So a profit warning is generally accompanied by a share price fall.

Investors in PMP (ASX: PMP), Ten Network (ASX: TEN), QBE Insurance (ASX: QBE) and Myer (ASX: MYR) unfortunately all have first hand experience!

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The Motley Fools purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, a podcast by David Kuo, originally appeared on fool.co.uk

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