Conventional wisdom dictates that when a company beats Wall Street's earnings estimates for a given quarter, its stock price should rise. But that's not always the case. In many instances, a stock's share price declines after better-than-expected earnings are reported.
Investors need to know that there is a reason for the decline in share price. It just might not be an obvious reason.
There are five major reasons for why a share price declines unexpectedly:
1. Major Shareholder Selling
Some institutional shareholders set a target to sell their stock at a given price or if a certain event transpires. The end result is that the supply of shares available for sale (after the event transpires) usually depresses the share price.
How can the average investor tell if a major shareholder is unloading his or her position? The answer can be found in the individual trade volumes on the tape.
For example, while individual investors typically make trades in the hundreds or low thousands of shares, institutions such as mutual funds often sell stocks in the tens of thousands of shares - or, even in rapid fire in low volumes of 3,000 or 4,000 shares.
So take a look at the tape and try to determine whether institutional selling is indeed driving down the share price. Once the selling is over, assuming the company's fundamentals remain intact, the stock price often jumps back up again fairly quickly. This creates a great buying opportunity for the long-term investor. (For more insight, read Institutional Investors And Fundamentals: What's The Link?)
2. Research Notes
Sometimes a sell-side analyst will put out a (negative) research note on the company either just before or just after earnings are released. This report (even if it is only slightly negative in nature) can affect the way that firm's clients think, especially those that are more short-term oriented. In any case, as a result of the analyst's commentary, some selling pressure often ensues. (Read more on this subject in Trading On News Releases and What Is The Impact Of Research On Stock Prices?)
While individual investors may have trouble accessing these reports, large newswires will often announce that a brokerage firm report has been issued, or the firm itself may release some information about the existence of the report to the general public. Again, the savvy investor may be able to use this information as a buying opportunity once the selling pressure subsides, assuming that there have been no fundamental changes in company.
3. Not Meeting the Whisper
Oftentimes, a company will beat the average Wall Street estimate, but fail to meet or beat the whisper number and, as a result, its stock price falls. The whisper number is simply an unofficial estimate, or rumor, that is circulating around Wall Street. Besides being aware of what that number is, there really isn't much an investor can do to defend against this. However, it does serve to explain some sell offs. (To learn more, read Whisper Numbers: Should You Listen?)
4. Faulty Numbers
Sometimes, there is a fundamental reason for a stock to fall after earnings are announced. For example, perhaps the company's gross margins have fallen dramatically from last quarter, or maybe its cash position has dwindled dramatically. The company may also be spending too much money on selling, general and administrative expenses (SGA) to pay for a new product launch.
Investors should carefully review earnings announcements to try to determine not only if the company beat earnings estimates, but also how it beat them. Determining the company's financial standing is of the utmost importance, as any shortcomings are bound to be reflected in the share price sooner or later.
Look specifically for any (sequential and/or year-over-year) changes in gross margins and operating margins. Also look for both sequential and year-over-year declines in cash balances. And don't forget to look for large one-time additions or subtractions from net income that could impact the way investors think. In the end, try to review what the analyst community and the media is saying immediately after the earnings are released, as their analysis of the situation may actually highlight an area of concern that you have overlooked. (For further reading, check out Earnings: Quality Means Everything.)
5. Future Guidance
Most public companies conduct a conference call after earnings are released. In this call, management may make forecasts or provide other guidance about the future prospects for the company. Investors need to remember that any guidance that is contradictory to what the investment community is expecting can have a material impact on the price of the stock. (Learn more about these meetings in Conference Call Basics.)
Investors should try to take part in the conference call or at least listen to the replay tape, which is often made available on the company's website an hour or two after the original call takes place.
There is almost always a tangible reason behind the downward movement in a given share price after earnings are released, but it's up to the investor to play the role of detective and to try to determine what that reason is. Those who are able to decipher the logic behind (and the source of) such market movements may be richly rewarded.