How Profits Affect Stock Prices | Invest 101


Every three months, earnings season is one of the most important times for equity investors. Now is the time to check out your favorite stocks to see how company fundamentals are supporting market performance, reassess your interest in these companies, and capitalize on expected price movements.

Whether the results are positive, negative, or somewhere in between, a company’s actions will respond. Investors aware of this dynamic can approach the earnings season with confidence and may be able to easily identify market opportunities. Here’s what you need to know about the relationship between earnings and stock price movements:

  • What are Income Reports?
  • Why are the gains important?
  • Why are market expectations important?
  • Can you use historical earnings performance to make future decisions?

What are income reports?

Publicly traded companies are required to file financial reports with the Securities and Exchange Commission on a quarterly and annual basis. These reports serve as a business biography, listing important financial data that informs investors about the overall health and stability of the business.

Profit reports are a quarterly overview of a company’s performance over a three-month period. But these results can provide a window into how a business will perform in the future. As a result, investors react to the news, directly affecting short-term stock prices.

One of the documents required with the SEC is the 10-Q, the quarterly financial report. It is the document most often cited when the stock market and the business media talk about profits. It includes unaudited financial records and provides an overview of the company’s financial position throughout the year, as well as a narrative summary of company highlights and outlook.

You can look at the 10-Q to compare metrics like the company’s last financial quarter revenue, profit, and adjusted profit to previous quarters to understand the company’s financial health. Investors can find a company’s 10-Q on its investor relations website or in the SEC’s EDGAR database, a tool you can use to find publicly available information about companies.

The 10-K is the annual financial report that publicly traded companies must file. The form provides a comprehensive view of the financial condition of the business which includes audited financial statements. Form 10-K is also available in the EDGAR database.

Why are the gains important?

Profit reports are important because they show the profitability and overall financial stability of the business.

These crucial financial statements are among the most important documents for investors to consult because they provide a window into income, expenses, debt, operations, and other metrics that measure the profitability of the business.

Depending on a company’s performance in its earnings report, investors can decide how to approach their position in a particular stock.

Liz Ann Sonders, chief investment strategist at Charles Schwab, says it’s important to look at the stock price in relation to earnings.

“The value of a stock is a function not only of the company’s profits, but also of the price of the stock,” says Sonders. Evaluating a stock involves looking at both its market price and its profits. This means looking at the price-earnings ratio, or PE, a key valuation metric for stocks.

Examining the PE ratio over time shows you whether the current ratio is above or below the historical trend.

Sonders highlights the review of the “E” component of the report. “If a stock is now trading at a much higher PE ratio than it was years ago, but there has been a significant improvement in the rate of earnings growth, then it’s a different story if you have a very expensive stock that is trading at a high level PE that has had a deteriorating earnings profile, ”Sonders said.

Investors can use historical PE data for a particular security to compare it to itself over different time periods or to other securities in similar industries.

Why are market expectations important?

Market expectations, as most often measured by analysts’ earnings per share estimates, set the tone for the likely performance of the company. If earnings results differ from these expectations, the price of a stock may respond by going up or down.

When a stock’s performance is trending higher and its quarterly earnings are positive, you may think its price will rise. However, it is possible that the stock price will fluctuate based on positive earnings or even its market value will decline.

It may sound counterintuitive. Why wouldn’t investors react positively to the news by buying more shares of a company when it produces positive earnings growth?

The answer: market expectations. If the company made money for a quarter and made a profit but investors were expecting spectacular profits, failing to meet those sky-high expectations can cause the stock price to drop.

If a company reports profits that are significantly different from expectations, it is called a profit surprise. This shock can cause the price of a stock to rise if earnings exceed expectations, or fall if earnings fall below expectations.

Another reason that a company’s stock price can fluctuate on positive earnings is because the company revises its outlook for future earnings or does not provide forecasts of future earnings, or its own expectations for future earnings.

Investors might see this as a red flag, forcing them to sell and putting a damper on the share price.

You may have heard the saying “Buy the rumor, sell the news” which means that market participants trade with the expectation of good news, which tends to position a market value higher. When the news actually comes out, this is when the stock might peak and some investors would have to sell because the stock tends to go down.

While a stock’s price rose during the quarter based on analysts’ positive earnings forecasts, good earnings are often built into the stock price before earnings are announced, said Anthony Denier, CEO of the Webull trading platform.

“If earnings are as expected and the stock rose as expected, most of the excitement has been built in,” he says. Investors therefore sell on the news.

On the other hand, if profits exceed expectations, the company performs better than expected. “Exceeding forecast prompts more investors to jump on the bandwagon and buy more stocks,” Denier said.

Can you use historical earnings performance to make future decisions?

While past performance is not necessarily indicative of future results, examining a stock’s historical performance can help investors anticipate future market movements.

Historical performance is important for investors because it provides reasonable parameters on stock movements, says Dan Raju, CEO and co-founder of the investment platform Tradier.

Investors can use a company’s historical performance to help predict how its stock might react when the company reports future earnings. The more data you have, the better you can identify performance patterns and make more accurate predictions.

“Historical performance is a lagging indicator that provides investors with basic knowledge to judge a stock’s future projections,” Raju said.

If a stock gradually rises and falls over a period of time, it signals to investors that this is standard behavior for a particular stock, Raju explains. But if the stock suffers a significant drop, it lets investors know that a major event is happening that could threaten the future of the company, he says.

To take with

Profit reports provide investors with the ability to judge a company’s performance. These financial results can have a serious impact on the share price, causing volatility. Don’t miss the opportunity to learn more about a company’s financial stability and understand why a stock’s price changes directly as a result of its profits.

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