How Stock Prices Correlate with Quarterly Earnings and When You Should Buy

How to Buy Stocks Based on Quarterly Earnings

When to Buy Stocks and How Stock Prices Correlate With Quarterly Earnings

Wall Street has an old saying that says “Earnings are what drive stock prices.” While this is true in the long term, many other factors can influence how a stock behaves before and after its earnings report.

These are often unpredictable. Even if a company does the right thing and generates high earnings, that might not be enough for the stock to rise. It is therefore risky to base an investment strategy on the date of earnings. This article will explain what drives the stock price in the short term and why even good earnings may not be enough to move it higher.

Price-Earnings ratio

The price-earnings of a company can influence whether or not its stock price rises after an earnings announcement. If a company has a high price-earnings ratio, then it must show high earnings growth to maintain its stock value. If the company can deliver on its promises, the stock price will likely continue to rise.

High-growth stocks can come with additional risk as their P/E ratios can decrease if their earnings can’t keep up.

Earnings and Revenue Expectations

Stock prices can drop even if a firm posts stellar growth in revenue or earnings. This is because of high expectations. Analysts and investors may expect a company’s earnings per share to be $2.00, but if they are only $1.80 instead, their stock price will fall. Even when a company exceeds expectations on revenue and earnings, its stock price may still drop if the market’s expectations are too high.

Starbucks, for example, released its Q2 2023 results on May 2 but the stock fell 5% after hours. The company’s earnings and revenue exceeded expectations by 14%. Same-store sales also increased 11%. Investors had hoped that the company would increase estimates and provide a more optimistic outlook, but instead, management simply repeated current numbers. It is dangerous to buy a stock that has high expectations.

Earnings forecasts

When a company announces its quarterly earnings, it usually provides commentary on both its results and internal forecasts for the next year. Even if earnings exceed estimates, a company’s stock price can drop if the management gives a poor forecast for the future.

CVS, for example, beat the market’s expectations when it reported its Q1 earnings in 2023, but its stock fell by 3%. The stock fell 3% due to CVS’s management reducing its earnings forecast by 20 cents a share to $8.50-$8.70. Investors backed off the stock because analysts had predicted the company’s earnings would be $8.76.

Investors may not be able to predict what the company’s management will see as far as upcoming earnings. This is why buying a stock before earnings are released can be risky.

External market factors

Stock prices are influenced by earnings over time, but in the short term, they are based on supply and demand. Even if a firm reports excellent earnings or bad earnings, its stock price may move up or downward based on market factors. Large institutional firms may decide to sell their shares at a loss or make a profit. They might also choose a different stock.

It is especially true at the end of each quarter when institutions “window dress” their holdings to look more impressive. It is difficult to predict these factors with certainty.

Bottom Line

There’s no way to predict how the stock price of a company will react to an earnings announcement. No matter if a company’s earnings are higher or lower than expected, the price-earnings (P/E) ratio, market expectations and management forecasts can affect its stock price.

Researching companies that consistently exceed expectations and demonstrate increased profitability is one way to play the earnings games. These companies can be long-term winners, even if they are volatile in the short term.

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