When news come in as expected
The accepted wisdom is that since prices are a function of expectations of future payoffs/ financial performance, company results have to exceed those expectations to have an increase in the stock price. When company announces results and only meet expectations, the stock stays put since it was already expected. Have stayed within my sector with this wisdom, all good and things work out this way.
However recently I've thought - when the company announces and meets expectations, doesn't the uncertainty baked into the stock price reduce? Shouldn't this be result in a reduction in the risk premium and thus a jump in the stock price by the amount of that risk premium?
What do people think
Wouldn’t the decrease in uncertainty be offset by the now decreased probability of an unexpected earnings beat and therefore jump in share price? It goes both ways, doesn’t it? Not in the industry, so definitely tell me if I’m off track here
Sorry I misread your question jn.
Well first of all assets don't price in unexpected earnings beats like that (gonna leave out WHY they don't for now).
Secondly, even if they did, think about what unexpected earnings mean - it means earnings can either have a surprise to the upside or the downside. Rn you're forgetting the downside
No, I’m saying that the upside and downside are both removed from consideration when earnings hit right on the mark, since neither were realized. Therefore, no move in price as earnings were as expected. The chances of both an earnings beat and miss respectively were priced in equally as the price reached a sort of equilibrium between both sides, so if earnings come in as expected, that equilibrium (the market price) doesn’t move. This is my train of thought, anyways. And yes, I’m aware it’s more nuanced than that, but this is the basics of what I’m asking
A stock price is just an expectation of discounted future cash flows. You can decompose into the immediate next cash flow (ie this coming quarter’s earnings) and future cash flows beyond that.
So if a quarter comes in line, that first cash flow is as expected and makes no change to the value. Any stock price change would then depend on how the market’s future expectation of cash flows is altered, either by the quantum or perceived riskiness (ie discount factor).
TLDR, stocks go up post earnings for three reasons:
1. Earnings materially outperform expectations, in which case the amount of the stock price increase should = the additional cash flow vs expectations for that period
2. increase in expected future nominal earnings (eg guidance improved)
3. Reduction in the discount rate - or perceived riskiness - the market places on a stock
this is the only correct answer
you need to consider time. If your DCF says the stock is worth $50 today over a 5 year period, a shift in time should result in accretion to that value if ur company is executing on its plan. A stock isn’t just worth $50 forever if ur DCF is 100% correct, the DCF is based on a cost of equity that is equivalent to your equity return if you bought the stock at that fair value figure.
Here is an example:
If you think a company has run rate 10% earnings growth in perpetuity and no yield, then your equity return is equivalent to your growth rate capitalised at the same multiple. Thus, if you hit expectations over a year, your forward year cash flow should have accreted at the same rate and your return should thus be 10% assuming no change in multiple
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