Confused by some of the share price reactions during earnings season?
You’re not alone.
So here’s a reminder of how it works:
Sometimes, profits go up. And the share price falls.
Sometimes profits go down. And the share price rises.
Sometimes, profits and share prices go in the same direction.
No, it’s not as random or clueless as it sounds, but it does take some explaining.
And the answer is in two words: ‘expectations’ and ‘outlook’.
Let’s take them in order.
Say your company delivered strong growth, with profits up 25%.
But if the company had provided guidance for 50% growth (or the market, feeling optimistic, had factored in 50% growth in the absence of company guidance), a 25% lift in earnings will be underwhelming.
So, a market prepared to pay $1 per share for 50% growth might only pay 90c for the lower actual result.
Hence: profits up, share price down.
And yes, you can reverse the situation:
Assume the market thought another company was in for a tough time. Shares had been trading a lot lower, on the basis that profits would be down 40%. But, in the event, the company did better than expected, and profits only fell by, say, 20%.
The share price might jump, as investors recalibrate their expectations for ‘bad, but not as bad as we feared’.
Hence: profits down, share price up.
(We’ll assume for our purposes that ‘profits up, share price up’ and ‘profits down, share price down’ are a little more self-explanatory. That’s not always the case, by the way, but that’s a discussion for another day.)
What about when profits are as good – or better – than the market expected, but the share price still falls?
That can be a case of ‘outlook’ being the Grinch at this particular Christmas party.
For example, a business might have had a good year last year (or last half), but that was due to one-off or temporary factors. So, it’ll say ‘hey, last year was great, but don’t expect it to last’.
Or it might be that given we’re getting towards the end of February and the books are closed off in December, the last 8 or so weeks have been underwhelming.
In that case, even though the reported numbers are real, and might be impressive, the market is (very reasonably) looking at more recent trading and factoring in that poorer performance.
So, yes, even when profits are up, and as good or better than expected, a share price can still fall.
And similarly, you’ll often see an ordinary set of numbers be passed over by investors, based on real and (hopefully) sustained recovery being shown in the last couple of months.
As crystal, or as mud?
If it’s the former, great.
If the latter, please do yourself a favour and re-read what I’ve written, above.
Because, as an investor, the sense of bewilderment when a share price doesn’t follow profits (in the short term, at least) can be pretty demotivating, sometimes.
It can make you lose confidence in yourself and faith in the market.
You can start to wonder if you’re really cut out for all this.
Pro tip: You are.
And, if you need it, here’s the good news: Over the long term, it’s almost invariably true that short term bumps and surprises are evened out.
Share prices, over a long enough period of time, follow business performance. And the longer your investing timeframe, the more likely that is to be true.
Some people learn to make their peace with volatility. Others just learn to ignore it, or endure it with gritted teeth.
What I know, from my own experience and the experience of others, over decades, is that buying quality at a reasonable (but not necessarily dirt cheap) price, being diversified, and having a long term perspective, is the best way to ride the waves of earnings season.
Which doesn’t necessarily make it easy – at least at first.
But give it time (and grit your teeth if you need to).
You’ll get there!
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Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.