Headline after headline say that companies “failed” and/or didn’t hit “targets”, but when you look at the numbers, the company made profits, sometimes in the millions to billions, it just wasn’t “enough”.
Is this greed? Why is it not good enough to make a profit?
In: Economics
If the market is pricing a stock at 10x earnings then stock price will be based on expected earnings. If earnings are $2 then stock price will be $20 aka 10x earnings. That means that if you can buy the stock below $20 at say $18 then it is undervalued and will likely go up in price to $20 soon which you will profit from. Likewise if the stock is currently priced above $20 at say $22 then it will likely come down to $20 resulting in losses.
The reason pricing is based on expectations is because different market participants forecast earnings to be different amounts and the market price represent all of their expectations weighted by how many shares are owned by each participant. That means the current market price is above what it should be based on expectations from some participants and below what it should be based on others.
Using simple math. Lets say there is a company “karma” which is releasing its earnings report tommorow. If 30% of investors beleive Karma will earn $2 per share then at a 10x price to earnings ratio. The correct value of karma shares is $2×10= $20.
Now the other 70% of investors think Karma has fundamental issues with their business model and expects earnings to come in at just $1.5 per share. To them the correct value of karma shares is $1.5×10= $15 which is lower than the other investors.
The market weighted average expectation of all investors is 30% of investors expect earnings of $2 and 70% expect earnings of $1.5 so ($2 x 30%) + ($1.5×70%) = $1.65 per share of earnings. Applying out 10x price to earning ratio means that karma should trade today at $16.5 per share. #the market price is a weighted average of differing investor expectations.
Now what happens when karma beats expectations and actually delivers $1.85 per share of earnings. All the 70% of investors have to accept that their estimate was wrong and the earnings are instead higher so if we update our pricing model to substitute $1.85 instead of $1.5 we get ($2 x 30%) + ($1.85×70%) = $1.895 per share of earnings or $18.95 new share price up from the $16.5 share price earlier.
You can see how if instead the earnings came in lower than market expectations the upbeat investors would have to revise their estimates down and it would lower the price I hope.
The TLDR is market prices are based on investor sentiment and guesses about company profitability. If actual profitability turns out below investor estimates then prices fall to reflect the new information. Vice versa when a company beats expectations prices go up to reflect the new information as well.
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