Why Stock Prices Fall After Beating Earnings

7 Reasons Why...

Feb 1

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Dear Friends,

I hope everyone has had a great week so far! As you might know, the Federal Reserve decided to raise interest rates by 0.25% today. However, they finally mentioned that they have future plans to stop the rake hikes which will be great for the stock market.

Another quick note, I sent out Meta to our premium subscribers at $137. Meta just had a massive earnings call today, and the stock is currently at $181 and going up which is a nice win for our investment club.

If you would like to read the case I made for Meta, then you can check that out right here.

If you follow the stock market news, you know that we are in the middle of earnings season. One of the questions that I get on a regular basis is “why do stocks go down after reporting good earnings?” It is a GREAT question.

In this newsletter, I will do my best to explain why this happens in a simple to understand way.

If you are a publicly traded company, you are required to post your earnings 4 times a year (each quarter.) This is required so investors can see how well a company is doing during the current market environment, and if they are meeting their annual projections.

Before these earnings are available to the public, "wall street analysts" come up with estimates on how they expect companies to perform. If a company beats these analyst expectations ("earnings beat"), this usually sends the stock up.

On the other hand, if a company fails to meet analyst estimates, a drop in the stock price usually follows.

More often than not, the days surrounding a company's earnings report release will naturally tend to be more volatile.

So, you should keep track of when your company's earnings reports are released to avoid making any poor investment decisions, such as investing all of your money into the company the day before earnings are released.

To understand how an earnings report affects a company's stock price, it's important that we look at 4 important performance metrics (among others) that consist of an earnings report. These metrics essentially define how a company performed since its last quarter.

Keep in mind, these are the 4 that I look at, and it doesn’t mean that I am right or wrong.

Metric #1: Revenue

The first metric you should look at is revenue (sales). This is the total amount of money a company generated over the past quarter for selling its products and/or services, not accounting for any costs to make this money.

In other words, revenue is pure money before any other number like costs of producing a product/service plays a part. In general, you should aim to invest in companies that regularly beat these revenue analyst estimates.

Metric #2: Earnings per Share (EPS)

Earnings per share (EPS) translates to the actual profits the company keeps. A higher EPS number means a company is more profitable, has the potential to grow faster, and can likely pay out more to its shareholders through earnings increase and/or dividends.

Metric #3: Unit Sales

The third metric is unit sales, which is simply the number of units a company sold in comparison to its previous quarter.

Typically, a stock's price movement will move due to a sales increase/decrease of one of its more popular products (if the company has multiple), and not one which has never dominated the industry market share.

One example of this is Apple (AAPL), a multinational technology company, and its popular iPhone smartphone product. This product line alone accounts for around 50% of the company's annual revenue.

So, even if Apple crushed earnings and EPS estimates for one quarter, a significant decrease in the number of iPhone's sold since the previous quarter could lead to Apple's stock price falling after the market opens. However, if investors had realized that Apple's average iPhone selling price had increased since the previous quarter, then the stock price would likely increase on market open instead.

Metric #4: Free Cash Flow

The fourth metric is free cash flow which is essentially the amount of money that the company can give back to their shareholders.

For example, let’s say a stock does $1,000,000 in revenue. However, they have a negative cash flow. This means that they are not profitable, and they can not “distribute” any money back to their investors.

On Shark Tank, Mr. Wonderful will always ask what the free cash flow is. Let’s say that Mr. Wonderful owns 10% of a business that has $100,000 in Free Cash Flow. This means at the end of the year, the business will distribute to him $10,000 in the form of owner distributions.

There is no difference between the Mr. Wonderful example and a stock that you own on the market. If a company has tons of free cash flow, they will reward investors in the form of dividends, share buybacks, or growth of the company which will make the stock go up.

Free Cash Flow is my favorite metric to study.

7 Reasons for Stock Prices to Fall After Earnings Beatings

Now, even if companies surpass analyst expectations for all five of the metrics covered in the previous section, there is no guarantee that the stock price will not drop after earnings are released! So, in this section, I will provide seven different reasons for why this may be the case.

1.Guidance

Guidance is when a company estimates what they expect their earnings to be moving forward.

If a stock has great earnings in Q1, but the company gives weak guidance for Q2 then the stock will go down because investors will sell on the news.

For example, let’s say that Apple just sold a record amount of iPhones in Q1. However, in Q2 they give us guidance that it won’t come close to Q1, then the stock will go down on this news.

2. Users/Subscribers

If a company like Netflix shows a slowdown of subscribers in their earnings report then it might scare investors into thinking that the companies revenue is slowing down.

Subscribers are what drives long-term profits for companies like Netflix, Snapchat, Spotify, Meta, and many more.

As an investor, we want to see them get more subscribers each quarter NOT less.

3. Change In Management

Let’s say Tesla had a RECORD earnings. This would cause the stock to go way up.

However, if Elon Musk announced that he was stepping down from Tesla, it would immediately make the stock go way down.

This happened to Meta, when they announced that Sheryl Sandberg would be leaving her position as the long-time COO.

However, there has been times when a bad CEO announces that he is leaving, and the stock price will go up. (How embarrassing!)

4. Dividend Increase

Most of the time a dividend increase is considered good.

However, if the stock has a cash problem and they increase the dividend then the stock will go down.

A stock needs tons of “extra” cash to raise the dividend.

5. Debt Levels

If a company beats earnings, but it has taken on tons of debt to grow the company then this will spook investors.

Good debt helps grow a company while bad debt will ruin the company.

It is important that you study these debt levels and make sure that your company has enough cash to pay it down!

6. High Expectations/ Sell-Offs

If every investor believes a stock will CRUSH earnings, then the stock will run up like crazy before it’s actual earnings date.

Most of the time, investors will take profit right after the earnings are announced causing the stock to go down.

This is a classic “buy the rumor, sell the news” event in the stock market.

7. Stock buybacks

Buybacks are usually GREAT for a stock. In fact, I rather a stock that I own do buybacks instead of offer a dividend. This is basically a cheat code for making the stock go up.

However, if the company has a cash flow problem or the stock is considered overvalued, then a buyback is a dumb idea which will cause the stock price to go down.