Whenever the price of a stock goes down after a superb earnings report, there tends to be some confusion among traders.
If you visit discussion forums on social media sites such as Reddit, you will find some people asking questions such as “Why isn’t the stock rising when the earnings report beat?” or “Why is falling?”
A good example is Coinbase (COIN) ‘s Q4 2021 earnings report. It smashed all expectations, yet its shares took a hit. Traders were quick to show their disappointment since many of them had expected the stock to shoot higher.
In this blog post, we will look at several reasons why a stock would slide even if the company happened to beat analyst earnings expectations.
But before we dive deep into our topic, let’s first briefly explain what the earnings season is and why it is important for stock traders and investors.
What is earnings season?
The term “earnings season” refers to the period when most publicly traded companies announce their quarterly or annual financial information.
In the U.S., the earnings season happens once every three months, or quarterly, for publicly traded companies. Therefore, there are four earnings seasons during the year—beginning in January, April, July and October.
However, there are no official dates that mark the kickoff and conclusion of the earnings season. The season generally begins about two weeks after the end of a quarter and lasts for about six weeks.
In some other countries, the season happens once every six months, or semiannually.
Earnings reports contain important financial and performance metrics. Many companies also usually hold a conference call with investment analysts and shareholders to present earnings to discuss the earnings.
Stock traders and investors eagerly await the reports to help them plan their next move. If a company tops expectations and has strong results, the price of its shares will likely go up. If a company falls short of forecasts, its stock will probably move lower.
Reasons why a stock would fall despite beating expectations
As mentioned before, most stock traders and investors naturally expect the price of a stock to go up if the company happens to report earnings that are higher than the estimates set by analysts.
Unfortunately, this is not always the case, and a stock may drop even if the company posts better-than-expected earnings. So why does this happen?
Weak guidance
Guidance, also referred to as ‘earnings guidance’ or ‘forward-looking statements,’ refers to analytical data that companies share with analysts and shareholders to keep them informed about the predicted future performance.
Generally, an earnings guidance contains information about estimated profit, losses, revenue, expenses, earnings, debts, and any other information relevant to the performance of a company.
Even though it is not mandatory for companies to explicitly publish/state their guidance, most of them usually provide a sort of “guidance” at their conference calls.
During these conferences, management usually talks about the future prospects for the company, including how they expect it to perform in the upcoming quarter.
Guidance can significantly affect the price of a stock. Even if a company reports strong results that are beyond forecasts, outlook regarding future earnings and revenue may not be as appealing and this can hurt the stock.
If a company beats earnings expectations, but provides a guidance lower than what analysts expect, this can drive a lot of traders out of the stock.
In some cases, a stock may also fall if a company provides a guidance equal to what analysts expect.
Volume of buyers (liquidity)
When there is a higher level of liquidity, large hedge funds and institutional traders will look to liquidate part of their larger positions.
If a large hedge owns a lot of shares in a company and wants to exit the position, they have to have enough buyers otherwise it will actually knock down the price of the stock.
Some stocks don’t have enough buyers until they release a superb earnings report.
The high trading volume after a company posts strong earnings often gives big hedge funds the opportunity to unload their large positions without affecting the stock price majorly.
When a company surpasses analysts’ expectations, they know many buyers will be available and the hedge fund or whoever has a big position will offload their shares. When big positions get dumped after a good earnings report, this may cause other traders to panic sell.
Buy the rumor, sell the news
“Buy the rumor, sell the news” is a trading strategy that promotes the idea of capitalizing on price movements by opening a position on a rumor, in anticipation of an event or announcement that could make the price of the stock to shift.
Let’s assume a trader expects that an upcoming economic report will affect the price of the price of a particular stock in a given way.
When the trader buys the stock based on this instinct, that is the rumor phase of the strategy. Once the report is published, the news has been made public. The trader then gets out of the position, and the stock moves.
In the case of earnings, many traders buy a stock a few weeks to months before its earnings reports gets released, knowing the stock will run up until earnings because every trader expects the company to “crush expectations”.
Once the company beats, these traders sell the stock to cash in on their profits.
Changes in management
Some companies may beat expectations and then decide to announce during their earnings call that a top executive, such as a CEO, COO, or CFO is getting replaced or leaving the company.
When a top executive leaves a company, traders and investors want to know why. When a new executive comes in, they worry about whether that is going to be bad or good for the company.
If the market interprets a change in management as bad, the price of the stock may fall. The drop may be bigger depending on the impact a certain executive has on the company in the past and how long their have been with the company.
Share buybacks
Share buybacks, also sometimes known as stock repurchases, are one of the ways companies return some of that excess cash to shareholders.
During an earnings call, the company may announce that the board of directors has passed a repurchase authorization.
If a company is performing well, has excess cash and its shares are undervalued, then a buyback could be a positive for investors and the stock.
But if the company is buying back shares while holding back on investing in its future growth or ignores other parts of the business, it is a decision that is likely to push its shares lower.
Panic selling
Panic selling could be another reason for the drop in share price after an earnings beat.
This is when you see a stock getting hit hard and you can’t help yourself. You see the stock fall 6%. Then down 9%. 11%. Down 14%.
Okay – you can’t take it. You sign into your brokerage account and click the “sell all” button.
A sense of panic can begin to set in despite a company topping expectations. Keep in mind that the market is not always rational and traders often make decisions based on their emotions.
Therefore, the long term fundamentals of a company are highly unlikely to matter to a trader who is watching their profits burn by the minute.
If you take these factors into consideration, you can easily see why a stock can go down despite crushing estimates. Fortunately, if the company has strong fundamentals and there is no any cause for concern, the stock will often rebound after a while.
Bottom Line
If you own shares in a particular company, earnings reports are a great way to stay up to date with its financial performance. The information contained in an earnings report may be a factor in deciding whether to sell some shares or buy more.
There is almost always a clear reason why a given stock drops after beating analysts’ expectations.
However, it is up to the trader to play the role of detective and to find out what that reason is.
Remember even if you don’t base your trading decisions on what happens during earnings season, other traders and market participants will—and, again, that can cause the stock to move and, potentially, the broader market.
Understanding earnings reports is just another important tool in your arsenal as you learn to be a better day trader.
