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Why Stocks Go Down When Company Profits Rise

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Have you ever invested in individual stocks because you had a hot tip that a stock was ready to shoot up in value? Or maybe you just got bored with your 401(k) and thought that you would try your hand at investing on the side? No matter what the case, I’m sure you soon realized that stock selection is not as easy as you may have originally thought. In fact, sometimes a company can earn $20 million more (in profits) than it did the year before, but their stock price takes a dive to half of the value it once had. What is the reason behind this? Does it make any sense at all?

Expectations Market

I used to think I was a big shot and invested in a few stocks here and there. In total, I probably only had $400 invested, and while I did make money, most of it was wiped away around tax time. All that work was for nothing. Back then I thought I knew all about the stock market. I factored in the asset-to-debt ratio, the debt-to-equity ratio, and even the most recent earnings per share (EPS). In reality though, I knew absolutely nothing about how stocks are valued and why they increase or decrease.

The first (and major) reason a stock price changes is due to the expectations of the company. I was totally oblivious to the reason before, but it has been proven to have a major impact on the stock price across all industries.

Each quarter, company and industry analysts predict what they expect various companies to achieve in the next quarter. If the companies do not meet the expectations of “the street” (as the analysts are often called), the value of their stock will almost certainly go down.

A few quarters ago, I discovered that my company was going to severely beat the expectations of the street. Since I had some insider information, I decided that I should not purchase any shares. I was certain that the stock would skyrocket in value though. To my dismay, the stock price actually went down… Why? Because my company’s forecast for the next quarter earnings was not as high as what the analysts thought it should be. They met one expectation, but not all of them so the stock price tumbled.

When investing in stocks for the short term, do not base your purchase on the consistent profits of the company. Rather, decide whether that company will beat all of the expectations of the analysts.

Economic Reports

Another large variable that has plagued company stocks has been the economic reports of the country. Every month, we all listen in on the updated employment reports. If they exceed expectations (yes, even the employment reports have expectations), then the stock market will most likely go up because of the “improved economy”. If there is a bad report, then the market as a whole go down. And, while this really shouldn’t affect all businesses, it quite often does.

When investing in stocks for the short term, be sure to factor in the success of the economy – not just the local economy, but the global economy as well.

Did you know that the stock values rise and fall on expectations?

Money

AUTHOR Derek

My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.

10 Comments

  1. I used to invest in individual stocks back in the 90s. I learned my lesson in 2000. I now only invest in low-cost passive index funds that are diversified across all markets and asset classes. I weathered 2008 much better because of that.

    • Index funds are the way to go. Sometimes individual stocks have their place, but only if you the companies incredibly well and are aware of their potential.

  2. I think that it is only partially driven by what the analysts are looking for.
    There are plenty of times that large hedge funds decide to simply dump their shares of a stock because they need to get more cash for the transactions fees … or at least it often seems that way.
    Consider it this way, they meet the street’s expectations and more, but they announce a lower then expected projected next quarter, so that the analysts will lower their expectations and the company looks profitable for the next quarter too. I rarely buy/sell based on what “the talking heads” say, although I listen to what they say to see what effect if any it has on a given stock, just for kicks.

    • I think you’d be surprised how much the expectations come into play for the price of the stock. And, unless a hedge fund is incredibly large, it would most likely have little impact on the rise and fall of the share price.

  3. That’s why I am very nervous about buying individual stocks. I much prefer broad ETF funds. If I do buy stocks, it’s usually something pretty well established. It seems the market can go up and down depending on anything.

    • Yep. I personally like Index funds myself, but I might consider purchasing some individual shares in the distant future.

  4. I didn’t know that before, but now I do. :)Thanks for that valuable information Derek!

    • You’re welcome Mark! I am actually fairly new to this realization as well. It’s a definite help when it comes to stock picking.

    • No problem Marissa. Glad I could help!


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