Why Do Stock Prices Fall Despite Good Earnings? Understanding Market Expectations Through Profit Forecasts and Interest Rates
“Sales and profits are at record highs. Yet, the stock price fell.”
During earnings season, we encounter this scenario time and again.
If a company announces strong results, the stock price should rise. Thinking this way, the market’s reaction might seem irrational.
However, what the stock price evaluates is not just the announced performance.
How much did those results exceed prior expectations? How have the future profit outlooks changed? And how much are investors willing to pay for those profits?
Breaking these three factors down makes it easier to interpret stock price declines following good earnings reports.
Earnings are both a report card of the past and material for the future
Earnings results are the outcome of a period that has already ended.
On the other hand, what investors who buy stocks receive is the value the company will generate from here on. Therefore, even if past numbers are good, the stock price can fall if expectations for the future weaken.
For example, consider a company whose operating profit increased by 20% year-on-year.
A 20% profit increase is an impressive achievement. However, if the market was expecting a 30% increase, the announcement falls short of expectations.
Furthermore, if the company forecasts a 5% profit growth rate for the next fiscal year, investor interest shifts from the past 20% growth to the upcoming slowdown in growth.
Here, even if the company’s business has not deteriorated, the expectations that were supporting the stock price are revised.
“Good performance” and “exceeding expectations” must be considered separately.
Stock prices can be thought of as the product of profit and valuation multiples
There is a basic formula for organizing stock prices.
Stock Price = Earnings Per Share (EPS) × Price-to-Earnings Ratio (PER)
EPS represents the profit a company earns per share, while PER indicates how many times that profit the stock price is valued at.
The following is an assumption to explain the mechanism.
If the expected EPS is 100 yen and the PER is 30 times, the stock price is 3,000 yen.
Suppose that after earnings are released, the expected EPS is raised to 110 yen. The profit outlook has improved by 10%.
However, if the P/E ratio drops to 25x, the stock price becomes 2,750 yen.
Even if profit forecasts increase, the stock price can still fall.
What is happening here is not a deterioration in profits, but a decline in the valuation multiple the market is willing to pay for those profits.
When you see a decline after good earnings, you can clarify the cause by first checking whether the EPS fell, the P/E ratio fell, or both.
When interest rates rise, the valuation of future profits changes
One of the factors that moves the P/E ratio is interest rates.
The value of a stock can be thought of as the future profits or cash flows it will generate, discounted to their present value.
The reason 1 million yen received in the distant future is not worth the same as 1 million yen received today is that you could earn interest by investing the money now.
The higher the interest rate, the smaller the present value of money received in the distant future becomes.
Therefore, companies that rely on future growth for the majority of their profits are more susceptible to changes in valuation due to rising interest rates.
However, the relationship between interest rates and stock prices is not mechanical.
If rising interest rates reflect a strong economy and corporate profits also grow significantly, the increase in profits may offset the decline in valuation multiples.
What is needed is not just to look at interest rates, but to read them in combination with profit forecasts.
Falling interest rates do not necessarily mean stock prices will rise
For the same reason, a decline in interest rates does not always lead to higher stock prices.
If inflation settles and interest rates fall while the economy remains stable, it is likely to be a favorable environment for companies.
On the other hand, if interest rates fall due to concerns about a sharp economic downturn, downward revisions to sales and profit forecasts may proceed.
Even if financing conditions improve, if profits fall by more than that, it will be a burden on the stock price.
When reading economic indicators, it is helpful to keep the following four combinations in mind to organize your thoughts.
Even with the same interest rate movements, the impact on companies changes depending on the background.
Look for the factors that changed profit forecasts rather than sales growth
When sales are growing in an earnings report, the business as a whole appears to be doing well.
However, the reason for the sales increase might be price hikes, while sales volume is actually decreasing. As a result of selling more low-margin products, sales may increase while profit margins decline.
Furthermore, if labor costs, logistics costs, depreciation, or interest expenses increase, sales growth may not translate into bottom-line profit.
What investors want to know, in addition to the result of revenue growth, is how much profit remains from that.
In earnings materials, try checking the operating profit margin and the factors behind profit changes after looking at the sales figures.
Even when a company revises its earnings forecast, do not judge based solely on the revision amount; you need to read what changed the outlook, such as volume, price, costs, or exchange rates.
Do not determine the cause based solely on stock price reactions
When looking at a decline after good earnings, explanations like “priced in” or “profit-taking” are sometimes used.
While such factors may be involved, you cannot determine the seller’s motivation based on the price drop alone.
Did long-term interest rates rise on the same day? Did competitors also fall? Was the profit margin outlook for that specific company weak?
By comparing these, it becomes easier to distinguish between company-specific issues and changes in market-wide valuations.
After earnings are released, checking in the following order will help organize your thoughts.
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Did the actual results exceed company and market expectations?
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How has the full-year profit outlook changed?
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Are there any concerns regarding profit margins or cash flow?
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How have interest rates and overall market valuations moved?
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As a result, what is the current stock price pricing in?
Market expectations vary depending on the institution and the timing of the survey. Furthermore, stock prices may sometimes incorporate expectations even higher than those publicly announced. It is important not to rush to conclusions based solely on a comparison of numbers.
Price is what connects a ‘good company’ to a ‘good investment’
A company may have excellent technology and growing sales and profits. Even for such companies, if expectations become too high, the room for further stock price appreciation may be limited.
Conversely, even if short-term performance is lackluster, if the stock price has already priced in a grim outlook, signs of improvement may be rewarded.
Of course, just because something looks cheap does not necessarily mean it is a good investment. You must verify the business’s competitive strength and financial stability.
What is important is to research the quality of the company and then consider how the current price is positioned relative to that value.
When a stock price falls despite good earnings, try asking yourself these two questions before changing your assessment of the company:
‘How has the future profit outlook changed?’
‘What multiple of that profit is the market willing to pay right now?’
The habit of separating profit from valuation multiples leads to decisions that are not swayed by earnings headlines or daily price fluctuations.
*Numerical examples are hypothetical and intended to explain the mechanism. They do not constitute a recommendation to buy or sell any specific stock.