Expectations matter
In many ways the performance of a company in the stock market mirrors how people build trust in the real world. If a person (or company) makes fantastic claims about being able to ‘revolutionize’ something, they have to be able to meet the expectations they create. The earnings report is therefore the chance for the market participants to assess whether or not a company can live up to the expectations investors have of it. In the case of Facebook, the price declines after the earnings report and after the IPO are a clear signal that either the expectations need to change about what Facebook is worth or that Facebook needs to work much harder to impress an increasingly skeptical audience.
How Professional Guessers Decide
When most professional longer term or fundamental investors look at using their capital to invest in a company, they often consider a number of parameters about a company that help them decide whether or not the company would be a sound investment. One of the most important things that potential investors look at is the company earnings, and whether or not the price they’re considering paying for earnings is reasonable given the risk they’re taking on.
Most publicly traded companies on major stock exchanges in Canada and the US are required to report their earnings on a regular basis in order to disclose how their business is doing to the general public, and more importantly, to their shareholders. It is often during this time period, sometimes known as “earnings season” that prices in stocks become more volatile, as earnings estimates are met, missed or exceeded.
It’s important to understand that market participants such as value and fundamental investors rely on these earnings reports to help make their decisions.
Often times there are analysts (the “professional guessers”) that focus on a small group (or even just one company) to try to estimate how well the company is doing and then base their investment decisions upon that research. Because these estimates are “best guesses”, when the actual reports are disclosed to the public, the accuracy of those estimates are tested and the prices of stocks adjusted according to the news reported within the earnings statement and the future guidance (if provided) of the company management. Whether the market participants like what they hear or simply dismiss it ultimately decides the share price.