Expectations - Or Why Bad Things Happen on 'Good' Earnings

People often ask why markets, or stocks, react in certain ways to news.  This is most often the case when stocks react in the opposite manner most people would expect, as when they go down on a report of growing earnings on an otherwise calm market day.  Or, when stocks go up on a huge loss.  These reactions would seem to make no sense.  The missing ingredient here is expectations. 

When you buy a stock, you own it for the future.  You don’t have a claim on past earnings.  It is worth the sum of all of the coming earnings (cashflows really, but this is for illustrative purposes).  (You would also present value those earnings, since a dollar tomorrow is worth less than a dollar today, but with interest rates so low let’s just skip that for now.)  So the market is pricing the stock based on how much it expects the company to earn going forward.  As shown in the table below, if a company earned $1 a share this year, and is expected to grow it by 6% a year for the next ten years, it would earn a total of $13.97 over those ten years (there would also be a terminal value, but once again I digress).  If the company’s earnings come in as expected, then the stock price should just grow along with them.  No problem so far.  The interesting part is when the company still grows earnings, but not as fast as the market expected.  Suppose instead, that the day after you buy the stock, the company announces that things aren’t going as expected so earnings are only going to grow 5% a year, not 6%.  That earnings stream would only be worth $13.21, or over 5% less than the expected earnings the day before.  The stock would then go down to reflect this lower future stream of earnings. 

 

	Prior Year		Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Total
Original Expectations
Earnings	1.00		1.06	1.12	1.19	1.26	1.34	1.42	1.50	1.59	1.69	1.79	13.97
Growth Rate			6%	6%	6%	6%	6%	6%	6%	6%	6%	6%
Revised Expectations
Earnings	1.00		1.05	1.10	1.16	1.22	1.28	1.34	1.41	1.48	1.55	1.63	13.21
Growth Rate			5%	5%	5%	5%	5%	5%	5%	5%	5%	5%

This is how stocks go down even as earnings grow.  Again, this is the basic version, and a company may not necessarily announce that it expects earnings to grow at a slower pace.  Instead investors may infer it, from other information, such as slowing revenue growth, shrinking margins, growing inventories etc.  The common denominator is that expected earnings would be reduced.  The same is true in reverse.  A company can lose money, but if it loses less than predicted, that could mean that the turnaround is closer than expected and so the sum of future earnings would be higher than currently forecast. 

The key point, is that in buying a stock, you have to not only know what you think the company will earn (a difficult enough task in and of itself), but also what the market believes that the company will earn.  In the above example, if you thought the company would earn 5% and bought it, but the market thought it would earn 6% and was wrong, you would end up losing money on it, even though you were right.  And that is how a stock can go down on positive earnings and why expectations are so important in investing.