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.

RELATED FAQS
  1. What is the difference between a long position and a call option?

    Learn what a long position in a stock is, what a call option is, and the difference between owning shares of a company and ... Read Answer >>
  2. Is maximizing stock price the same thing as maximizing profit?

    Simply put: yes. A company's stock price will factor in many different variables including the type of industry the firm ... Read Answer >>
  3. Why do share prices fall after a company has a secondary offering?

    The best way to answer this question is to provide a simple illustration of what happens when a company increases the number ... Read Answer >>
  4. How do I calculate the adjusted closing price for a stock?

    When trading is done for the day on a recognized exchange, all stocks are priced at close. The price that is quoted at the ... Read Answer >>
  5. If a country's currency is determined by the strength of its economy, why isn't the ...

    Generally speaking, when Country A's currency is worth more than that of Country B, it does not necessarily mean that Country ... Read Answer >>
  6. How do I use the PEG (price to earnings growth) ratio to determine whether a stock ...

    Using the PEG, or price/earnings to growth, ratio provides a better picture of a stock's valuation versus simply relying ... Read Answer >>
Related Articles
  1. Investing

    Everything Investors Need To Know About Earnings

    We go over the concepts behind the excitement over the most important figure in the stock market.
  2. Investing

    How To Find P/E And PEG Ratios

    If these numbers have you in the dark, these easy calculations should help light the way.
  3. Investing

    The Pros and Cons of Sell-Offs

    A sell-off is the rapid sale of a security that’s followed by a drastic decline in its value.
  4. Managing Wealth

    How to Use Earnings Season to Make Better Decisions

    Earnings season reflects the state of the stock market, but also demonstrates how the overall economy is performing.
  5. Trading

    Forces That Move Stock Prices

    You can't predict exactly how stocks will behave, but knowing what affects prices will put you ahead of the pack.
  6. Trading

    What Does It Mean When an Option is At The Money?

    The strike price of an at-the-money options contract is equal to its current market price. Options that are at the money have no intrinsic value, but may have time value.
  7. Investing

    What Is Year Over Year?

    Year over year measures performance in one time period versus performance in a previous time period.
  8. Investing

    Understanding Long/Short Equity

    A long/short equity investing strategy takes long positions on stocks that are expected to appreciate, and short positions on stocks expected to decline.
  9. Investing

    What is Cash Basis Accounting?

    Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.
  10. Investing

    How Are Futures Used To Hedge A Position?

    A futures contract is an arrangement two parties make to buy or sell an asset at a particular price and date in the future.
RELATED TERMS
  1. Short (or Short Position)

    A short position is the sale of a borrowed security, commodity ...
  2. Specific-Shares Method

    A personal financial accounting method that, when used properly, ...
  3. Valuation

    The process of determining the current worth of an asset or company. ...
  4. Earnings

    The amount of profit that a company produces during a specific ...
  5. Book Value Of Equity Per Share - BVPS

    A financial measure that represents a per share assessment of ...
  6. Directional Trading

    Trading strategies based on the investor’s assessment of the ...
Hot Definitions
  1. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  2. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  3. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  4. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  5. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  6. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
Trading Center