There’s an old axiom on Wall Street that “earnings drive stock prices.” Over the long run, it’s true that a company’s profitability has a direct effect on its stock price, but a number of factors can affect how a stock acts going into and just after it releases its earnings report.
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Many of these are unpredictable. Even if you think a company is doing the right things and generating high earnings, it might not be enough to move the stock higher. This makes basing an investment strategy around an earnings release date a difficult or even risky strategy. Here’s a look at what drives stock prices over the short run and how even good earnings might not move a stock’s price higher.
Price-Earnings Ratio
Whether or not a stock price will rise after an earnings release can depend in part on the company’s price-earnings ratio. If a company carries a high P/E ratio into a quarterly report, it will have to show a high growth rate in its earnings to keep its stock price up. If it can deliver, its stock price is likely to continue rising.
However, high-growth stocks come with added risk, as their price-earnings ratios can shrink if they can’t keep their earnings up to pace.
Earnings and Revenue Expectations
Even if a company posts a stellar growth rate in its revenue and/or earnings, its stock price can fall due to elevated expectations. If analysts and investors expect a company to earn $2.00 per share and they only earn $1.80, the stock will often fall. Sometimes, even when a company beats on both revenue and earnings, the stock price can still fall if market expectations are too high.
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For example, Starbucks released a glowing Q2 2023 earnings report on May 2, but the stock still fell 5% in after-hours trading. Both earnings and revenues topped expectations by about 14%, and same-store sales rose 11%. But investors were hoping that the company would raise estimates and lift forward guidance, and instead management simply reiterated current numbers. This highlights the danger in buying a stock with high expectations attached to it.
Earnings Forecasts
When a company releases its earnings report, it typically provides commentary regarding both the results for the quarter and its internal forecasts for the coming year. Even if earnings beat estimates, a stock can fall if management provides a sour forecast for the future.
For example, when CVS reported its Q1 2023 earnings, it beat market estimates but its stock still fell 3%. This was due in large part to CVS management cutting its earnings forecast for the year by 20 cents per share, to the range of $8.50 to $8.70. As analysts were previously predicting the company would hit $8.76 in earnings, investors backed away from the stock.
As an investor, it can be hard to know what company management is going to see in terms of upcoming earnings. This is one of the factors that can make buying a stock before an earnings release risky.
External Market Factors
Although earnings move stock prices over the long run, in the short-term, the stock market operates on a supply-and-demand basis. This means that even if a company reports great earnings — or poor earnings — its stock price might move up or down based on external market factors. Big institutional firms with a large number of shares might want to take a profit, or a loss, or may simply decide they’d prefer owning a different stock.
This is particularly true near the end of a quarter, when a process known as “window dressing” occurs and institutions try to make their holdings look more impressive. These factors are hard to predict with any certainty, though.
Bottom Line
Unfortunately, there’s no easy way to know how a company’s stock price is going to react to an earnings release. Regardless of whether a company beats or misses its numbers, its price-earnings ratio, market expectations, management forecasts, supply and demand and other factors can drive its price up or down.
One way to play the earnings game is to research companies that consistently beat expectations and show increased profitability. Even if you have to endure short-term volatility around an earnings release, these types of companies are often long-term winners.
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This article originally appeared on GOBankingRates.com: How Stock Prices Correlate With Quarterly Earnings and When You Should Buy
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
