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I often see news reports along the lines of "Company X has posted a profit of $100 million, 20% lower than the previous year." This kind of news frequently causes the company's share price to fall.

But I'm thinking: the company still made $100 million profit, so the company gets richer — it has $100 million more than the previous year.

So why would the share price fall? It seems paradoxical. If every year the company saves its profit in the bank, then each year the company will grow richer, even though current profits might have been lower. So why would the share price fall? What is it about how stocks are valued that I'm overlooking?

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Objectively company total value should be the [best estimate of] assets-liabilities + sum of all future profits (discounted to today's value). For most 'good' companies, the second part is overwhelmingly larger than the first. If the future profits (or just estimates of them) shrink, then the value of each share (i.e., part of all that jucy future profit) naturally is worth less. –  Peteris Mar 14 at 11:21
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I covered a bit about the psychology of the market in a response to an SEC inquiry a few years ago: zxq9.com/archives/461 (the inquiry was about increasing regulation on short positions, but the issues are identical). TL;DR: there is so much liquidity in the system that emotion trumps actual data in perceived valuation; just as in politics, the imagined state of the world demonstrates significant distance from the actual state of the world. –  zxq9 Mar 15 at 9:06
    
@zxq9 - a very good and valid point. Totally agree. The powers of fear and greed. –  Victor Mar 15 at 11:02

7 Answers 7

It has got to do with market perceptions and expectation and the perceived future prospects of the company.

Usually the expectation of a company's results are already priced into the share price, so if the results deviate from these expectations, the share price can move up or down respectfully. For example, many times a company's share price may be beaten down for increasing profits by 20% above the previous year when the expectation was that it would increase profits by 30%. Other times a company's share price may rise sharply for making a 20% loss when the expectation was that it would make a 30% loss.

Then there is also a company's prospects for future growth and performance. A company may be heading into trouble, so even though they made a $100M profit this year, the outlook for the company may be bleak. This could cause the share price to drop accordingly. Conversely, a company may have made a loss of $100M but its is turning a corner after reducing costs and restructuring. This can be seen as a positive for the future causing the share price to rise.

Also, a company making $100M in profits would not put that all into the bank. It may pay dividends with some, it may put some more towards growing the business, and it might keep some cash available in case cash-flows fluctuate during the year.

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This. In fact, you wouldn't be too wrong to say that the stock value of the company is not really determined by its revenue but by what 'analysts' think the revenue should be. So, company makes 1M revenue but analysts thought it would be 1.1M, stock goes down, but if analysts thought it would be 900K, stock goes up. Now I wonder who determines who those 'analysts' are, and if they don't manipulate the market for their own benefits sometimes. –  Rodolfo Mar 14 at 19:20
    
@Rodolfo - analysts usually base their analysis on information provided by the company during reporting seasons and during updates throughout the year. But analysing a company's financial position is not an exact science and can be based on various assumptions at times. –  Victor Mar 14 at 21:16
    
Also, a company's share price can change for a whole range of reasons, some rational, some irrational. An institution placing a large sell order to rebalance its portfolio can cause the share price to tumble, and vice-versa. –  Victor Mar 14 at 22:22
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Another way of phrasing this is "People are irrational, and also greedy." –  Carl Witthoft Mar 15 at 21:31
    
@CarlWitthoft - exactly, but you forgot fearful as well. People are irrational, greedy and fearful. And fear is a greater emotion than greed, that is why when the market starts falling it can fall quite steeply and quickly. I have heard of an up-trend been described us someone climbing up a set of stairs, and a down-trend as someone reaching the top of the stairs and falling off the edge. –  Victor Mar 15 at 21:39

The company's value (which should be reflected in the share price) is not how much money it has in the bank, but something along the lines of 'how much money will it make between now and the end of times' (adjusted for time value of money and risk).

So when you purchase a share of a company that has, say, little money in the bank, but expects to make 1M$ profit this year, 2M$ for the following 3 years, and say, nothing after, you are going to pay your fraction of 7M$ (minus some discount because of the risk involved). If now they announce that their profits were only 750k$, then people may think that the 2M$ are more likely to be 1.5M$, so the company's value would go to ~ 5M$. And with that, the market may perceive the company as more risky, because its profits deviated from what was expected, which in turn may reduce the company's value even further.

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You are omitting how the company made 120 million in the previous year and may be facing a shrinking market and thus have poor future prospects. If the company is shrinking, what will the shares be worth down the road.

Remember companies like AOL or Blackberry? There was a time they had big profits before things changed which is the part you aren't considering here. If the company has lost something big on its earnings, e.g. the oil wells it owned have run out of reserves or the patents on its key drugs have expired, then there could be the perception that the company won't be able to compete in the future to continue to deliver earnings. Some companies may well end up going broke as one could look at GM for a company that used to be one of the largest car companies in the world and yet it ended up going broke.

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Aside from the market implications Victor and JB King mention, another possible reason is the dividends they pay. Usually, the dividends a company pays are dependent on the profit the company made. if a company makes less profit, the dividends turn out smaller. This might incite unrest among the shareholders, because this means that they get paid less dividends, which makes that share more likely to be sold, and thus for the price to fall.

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Let's say you see a café. You're looking to buy a café so you walk into one and ask the manager how much profit he makes in a year. He says $N and you walk out and think to yourself, "I'd be willing to pay $500,000 for this café." You arrange to meet again to discuss purchasing the business (and he's looking for someone to purchase it).

You go into the store again the following day and the manager says, "Sorry, I told you we make $N. I've checked the numbers and it's actually only $0.8N (20% lower than what you thought)."

Are you still willing to buy the café for $500,000 as well? No, of course you're not.

I think that this is a sufficient analogy to public companies.

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In a rational market, the market caps (total value of all shares of the company) should be determined by the expected future profits of the company, plus the book value (that is the value of all assets that the company holds). The share price is then calculated as market caps divided by number of shares - a company worth a billion dollar could have a million shares at $1000 each or a billion shares at $1 each or anything in between.

When profits drop, every investor has to re-think what the expected future profits of the company are. If all the investors say "I thought this company would make a billion profit in the next ten years, but based on the drop in profits I changed my mind and I think they will only make 500 million", then the share price drops. On the other hand, if profits dropped because of some predictable event, then that drop was already priced into the share price. If the profits dropped less than expected, the share price might even go up.

You can see the opposite effect: Share price might be very high because everyone expects huge growth in profits over the next ten years. If profits grow less than expected, the share price will drop. Share price depends on predicted future profits, not on profits today.

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Let's use an example:

You buy 10 machines for 100k, and those machines produce products sold for a total of 10k/year in profit (ignoring labor/electricity/sales costs etc).

If the typical investor requires a rate of return of 10% on this business, your company would be worth 100k. In investing terms, you would have a PE ratio of 10. The immediately-required return will be lower if substantially greater returns are expected in the future (expected growth), and the immediately required return will be higher if your business is expected to shrink.

If at the end of the year you take your 10k and purchase another machine, your valuation will rise to 110k, because you can now produce 11k in earnings per year. If your business has issued 10,000 shares, your share price will rise from $10 to $11. Note that you did not just put cash in the bank, and that you now have a higher share price.

At the end of year 2, with 11 machines, lets imagine that customer demand has fallen and you are forced to cut prices. You somehow produce only 10k in profit, instead of the anticipated 11k. Investors believe this 10k in annual profit will continue into the forseable future. The investor who requires 10% return would then only value your company at 100k, and your share price would fall back from $11 to $10. If your earnings had fallen even further to 9k, they might value you at 90k (9k/0.1=$90k). You still have the same machines, but the market has changed in a way that make those machines less valuable.

If you've gone from earning 10k in year one with 10 machines to 9k in year two with 11 machines, an investor might assume you'll make even less in year three, potentially only 8k, so the value of your company might even fall to 80k or lower. Once it is assumed that your earnings will continue to shrink, an investor might value your business based on a higher required rate of return (e.g. maybe 20% instead of 10%), which would cause your share price to fall even further.

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