A:

More often than not, when a firm releases an earnings report the market will react to this news by adjusting the firm's stock price. This stock price is based on the expectations investors have for the firm's earning potential. Earnings are a significant underlying evaluation factor when determining the price of a stock; they are also a factor that could change a stock's price very quickly.

If a firm issues an earnings report that does not meet investors' expectations, the stock's price will likely drop. For example, let's say that XYZ Corp. has a forecasted earnings per share of $0.75, and historically, the firm has never missed an earnings target. Investors, on the other hand, believe that XYZ will earn more than $0.85 per share, and think that the firm is currently undervalued. Let's say that XYZ releases an earnings report of $0.83 per share. That seems like good news (they beat the analyst's forecast), but investors see this differently. Because they believed that XYZ should earn more than the $0.83 per share before its earnings were announced, the stock's price was actually bid upwards to a price that reflected that earnings expectation. Because the earnings of $0.83 per share is less than what the current market price can support, the stock price will fall as investors sell off their shares.

Another possible explanations for a news report creating a sell-off of a stock could relate to noise traders. A noise trader does not analyze the fundamentals of a prospective investment. Instead, noise traders make trades based on news or technical analysis indicators. For example, suppose that XYZ has the same forecasts and results as above, and there is a sell-off of the stock. A noise trader who is watching the sell-off occur will follow the trend and sell his or her shares too. This will cause an even steeper decline in XYZ's stock price.

While there are many possible explanations for this type of phenomenon, the most important thing for an investor to remember is to think more about the long-term profitability of a company. For example, an avid investor may see the sell-off as a good time to buy into XYZ (hey, they beat earnings), and take a long position in the belief that XYZ will continue to be profitable.

To learn more, check out the Stock Basics tutorial and Everything You Need to Know About Earnings.

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