The Impact of Earnings Surprises on Stock Prices
3 min read
If a company’s earnings announcement falls below expectations, it usually leads to widespread selling on Wall Street and can affect markets for days or even weeks – this demonstrates investors’ sensitivity when faced with unexpected information.
Kothari et al. conducted a recent study analyzing stock returns, aggregate earnings surprises and behavioral finance using listed firms.
The Impact of Earnings Surprises on Stock Prices
Efficient market theory would predict that once earnings surprises are announced, stock prices would quickly adjust to reflect new expectations. But decades of research have demonstrated otherwise; on average, stock prices typically continue to fluctuate for days, weeks, or even quarters following an earnings announcement by company. This lingering effect is known as postearnings announcement drift (PEAD), providing arbitrage opportunities to those investors able to read news correctly.
This phenomenon can be explained by analyst forecasts tending to underestimate EPS, leading to unexpectedly large earnings surprises when actual results exceed expectations (EPS jump). There may also be firm-specific effects, with “high-reputation” firms and “celebrity” firms having less dramatic PEAD returns than others.
Understanding how earnings surprises affect stock prices can be key for investors seeking to navigate sector volatility and take advantage of opportunities in the stock market. But as is always necessary when investing, diversifying your portfolio and conducting thorough research are necessary in managing risk effectively.
The Impact of Positive Surprises on Stock Prices
The efficient market hypothesis suggests that stocks will respond to earnings surprises by altering prices accordingly, although this process may take months or even years before completion. This phenomenon is known as post-earnings-announcement drift and has been extensively studied.
Numerous factors contribute to this drift. Earnings surprises tend to have greater ramifications on stock prices when followed by other positive or negative announcements, while market conditions also play a part in this phenomenon – for instance, strong earnings news during an upmarket environment can boost investor trust and create ripple effects among related firms’ stocks.
Conversely, disappointing earnings news in an uncertain market can have the opposite effect, prompting sell-offs that extend well beyond just those shares reported by the reporting company. Researchers have discovered that earnings surprise announcements play an integral part in shaping market reactions.
The Impact of Negative Surprises on Stock Prices
Positive surprises may lead to higher stock prices; negative ones have the opposite impact. Furthermore, their effects may be further complicated by external factors like macroeconomic conditions or industry shifts that disrupt earnings surprises. Furthermore, investors often fail to properly account for persistent earnings that lead to misalignments between announcement window returns and long-term returns (Milian 2015).
Efficient market theory assumes that when a firm announces an unexpected earnings surprise, stock prices would quickly and accurately reflect new implied expectations. Yet decades of research have demonstrated that stocks don’t fully react to earnings surprises; rather, post-earnings-announcement drift is often apparent.
Reasons for this drift remain elusive. One theory suggests that investors do not take into account key bottom line metrics like BVPS and EPS when making investment decisions; as a result they rely too heavily on older elements of an earnings time series like past earnings, current estimates, or prior expectations when making these important choices.
The Impact of Concurrent Announcements on Stock Prices
Publicly traded companies disclose earnings quarterly, giving investors insight into company performance and expectations. While earnings surprises tend to create positive stock price reactions, evidence exists of post-earnings-announcement drift (PEAD), suggesting that investor behavior and other factors may impact how quickly prices adjust to new information.
One potential reason for the PEAD could be that investor expectations are affected more by relative content of news than by its absolute value; for instance, an earnings surprise that comes shortly after an upgrade could influence how people react to it.
Increased PEAD in negative surprises could also be related to short-selling activity, since when stocks experience large surprises short-sellers often sell their positions simultaneously to limit losses and drive down prices (see figure below). This effect is amplified among stocks with greater retail trading activity.
