Stock Prices and Earnings Announcements

Abstract

Stock may be described as a share of ownership of a company through an investment undertaking into the company’s equity. Basically, business stocks are basically meant for spreading risk and are divided into shares which are stated during the formation of the business, with a face value which represents the total amount of money invested in a business. The earnings can drift after the announcement of earnings, for instance, the stock has a tendency of experiencing unexpected earnings increment or decrement and continues to move in the same direction, a process called drift. The prices of stock keep on fluctuating depending on the economic activities that are prevailing in the market including the divergence of opinion (Fabozzi, 2004, p. 159). Generally, prices increase when there is an increase of opinion divergence and decreases when there is a fall in opinion divergence. Moreover, a single political, social or economic announcement concerning a given company or country is enough to cause a significant change in the stock prices. Taking into consideration of a stock where most of the related information concerning its value is announced every quarter after the release of earnings, there will be considerable uncertainty about what future earnings will be. It is highly possible that there will be a divergence of opinion concerning the value of such a company as well as concerning the future earnings. This paper tries to investigate how stork market responds to public announcements of information concerning the new value, with the bulk of the context of the paper discussing how the earnings announcement impact on the prices of the stock.

Introduction

The fluctuation in the stock prices is mainly triggered by, among others, the earnings announcement which has either short-term or long-term effect on the company’s performance mainly due to the fact that stock prices highly depend on the people’s confidence and faith they have in the company. Thus, any announcement which tends to infringe people’s trust on a company automatically leads to fluctuation in stock prices, for instance reports bearing profits increase investors’ confidence while losses lead to decline in investors’ confidence, with stocks prices following suit directly. In addition, the stocks’ market prices are noticeable and reveal the average attitude of the current and potential shareholders on the value of the company (Budde, Felcht, and Frankemölle, 2006, p. 13). Considerable differences between fundamental value creation and its capital market assessment are seen in the stock prices. A negative announcement in most cases leads to a downward shift in stock prices while a positive announcement brings forth an upward shift in stock prices. This paper will seek to analyze how earnings announcements reflect on stock prices in short period of time (Budde, Felcht, and Frankemölle, 2006, p. 13).

Literature review

The concept of earning management (EM) tries to investigate whether the executives can opportunistically control the reported earnings from moving up or down. In addition, a company may be forced to control its reported earnings down to reinforce its claims of harm from other contestants as well as their products. It is predicted that the stock prices increases in reaction to strong but unexpected performance and decreases if the performance tends to be poor. If the markets are effective, then prospect performance showed by all current public information can be expected in the current stock price and there should not be any reactions from the stock price once the performance is attained as expected. Observations have been made that the stock price of a company that announces strong earnings performance has a tendency of drifting upwards for a considerable period of time after the date of earnings announcement. However, the reverse is true for the companies that are performing poorly (Rabin, 2003, p. 19).

Stock prices can be determined by factors which have either a direct or an indirect impact on the company concerned. Earning announcement in a given company is one of the major factors which play a major role in the stock price determination. It is important to note that company earnings are basically used to gauge the performance of a company whereby, in case of a positive announcement a change in people’s perception towards the firm raises the stocks demand thus leading to an increase in stock price. Many view capital markets as primarily responding to short term income variations, with the demand to achieve earnings per share expectation creating pressure that forces the managers to focus on the short term rather than the long term value creation. This is because most of the major variables for long term value creation, like the R&D investments, are likely lower or suppress the earnings in the short term (Budde, Felcht, and Frankemölle, 2006. p. 13).

There are models that are generally used to interpret the movements in company common stock price indexes. One of the simple models used implies that real stock prices are equal to the present value of logically anticipated or optimally foreseen future real bonuses discounted by a constant real discount rate. This model of valuation is normally used by economist analysts to explain the behaviour of average market indexes and it provides reliable information on what accounts for a sudden movement in stock price indexes. There are claims that stock price indexes are too volatile. The movement in stock price indexes may not, in real sense, result from any new information since the alterations in price indexes appear to be very big compared with actual subsequent events (Thaler, 1993, p. 107).

Dividends declaration, share split and any other new information concerning the company’s performance have a great impact on stock price determination, as investors’ confidence is enhanced by potential gains from the company. Share split is done whenever a company feels that the price of its shares is higher than the budgeted or targeted value, thus reducing the share price and making the shares more affordable to the public. The high returns preceding the split raises company’s tocks demand as people anticipate benefiting from the split, especially increase in dividend earnings. Usually, dividends are assumed to emanate from sound management practice, and although managers/directors may declare low dividends to cushion potential future declines, a constant declaration of dividends makes people to develop faith in a certain management, thus increasing the demand of stocks from the company.

A company’s stock price varies mainly in reaction to revised shareholder prospect concerning the timing, amount as well as the uncertainty of its probable cash flow. Challenged by the earnings surprises, shareholders try to measure how long they can wait for the unexpected fraction of earning to last (Rabin, 2003, p. 18) as the demand increase and reduction in the market is the major contributor of stock price fluctuation. In case of a negative economic announcement such as occurrence of loss in a given company, a decrease in stock price will be observed as people will start loosing faith on the company. Although people will blame the management for failure, other factors such as economic recessions might have significantly contributed to the acute loss. It is therefore true to state that the earnings announcement has a great impact on the demand of company’s stock in the market, something which later translates to either price increase or reduction.

Whenever people use declining company earnings announcements to make decisions on whether to purchase or not to purchase the company’s stock, a biased decision might be reached. This is because if the poor economic performance improves in the long run, people will count losses (lost opportunity) for not buying the company stocks when they had time to do so. The major problem which accompanies such decisions is that the company’s reputation may end up being ruined and thus resulting to a negative impact in the overall company’s performance. It has been demonstrated that share prices respond to the earnings announcements as well as the announcement concerning company control, regulatory policies, in addition to the macroeconomics that affect the fundamentals; however, it is difficult to substantiate that only information affects asset values (Thaler, 1993, p. 133).

In order to change the attitude of using earnings announcement as a determining factor towards the public’s decision to purchase the company’s stock, much sensitization should be done with an aim of alerting the public on other viable options that a company may have such as operation diversification. The public should also understand that incase the company fails to announce earnings due to diversification reasons, there is no operation negativity as the company is more likely to perform well in long run. Generally, stock prices react to the actual and projected company earnings; therefore, an efficient market should allow the stock price to respond to the announcement within a few moments from the release of the information, failure to which the market is considered to be ineffective especially where investors can reap abnormal gains (Moyer, McGuigan, and Kretlow, 2009, p. 41).

For better illustration of market effectiveness, let’s consider an example of Dell which announced its earnings on May 12, 2005. After the close of business the company announced that it had made $0.37 earnings per share in the quarter that passed corresponding to analyst anticipations for the stock. Furthermore, the company announced an additional favourable prospect for earnings in the next months that were unanticipated. This encouraging news led analyst and investors to allocate a higher appraisal. The increment in value was reflected instantly in Dell’s stock price, reliable to an effective market. The stock closed at $36.61 on May 12, 2005 before making the earnings announcement. In the period that preceded this earning announcement, the stock price was at an average of $37. One day after the announcement, Dell’s stock price displayed a sharp leap to close at $39.33. This corresponded to 7% larger than the closing price of $36.61 on the previous day. Dell’s stock price was sustained at the price of about $39 for a number of days that followed. As it can be seen, the stock price took a very short time to respond to the earnings disclosure. This illustrates that one could easily earn a lot of profit by carrying out business on the stock immediately after the earnings announcement. For positive information one would buy the stock immediately after the release of information and sell it few days later when the price of the stock has reasonably risen. On the other hand, if the information is negative, one can make profit by selling the stock immediately and then buying it when the prices have stabilized at a relatively lower price. The latter is known as short selling where one sells a stock that he or she doe not own but borrows from other investors and the return later after purchasing it definitely at a lower price (Moyer, McGuigan, and Kretlow, 2009, p. 41).

The public should learn more on when to buy and when to sell securities. Timing is an important aspect, and should not be entirely pegged on earning announcement, given that companies may exaggerate or manipulate reports in a bid to lure investors’ confidence. For instance in some cases, companies view that, by announcing some earnings to the stakeholders, they win the public support and therefore tends to shield themselves from bad publicity. In most cases, annual general meetings (AGMs) act as the platform for convincing the investors on matters related to earnings that may have an effect on the stock price. Indeed, unconvincing reports may see the stakeholders fire the existing management team if they feel that the team does not effectively maximize their wealth, a phenomenon that may be detrimental to the company’s profitability in the short term (Moyer, McGuigan, and Kretlow, 2009, p. 41).

The trend of relying on the earnings announcements to make investment decisions has been implanted in the public minds and has gone to an extent of becoming a culture, making it hard to change. The companies should therefore strive to report earnings that are sustainable in future because any subsequent reduction in future may greatly have adverse impact on the company’s stock price as the general public will view this as a decline in the company’s performance. It is therefore better for the company to start off with low distribution of earnings to the stakeholders and improve the earnings as the time goes by in order to build public confidence about the company (Thaler, 1993, p. 134).

Earnings announcements also give the public a room to speculate on the company’s future, for instance, when the company fails to announce any earnings within a specified duration of time, it might give an implication that the same move might be extended in the future. This may lead to panic withdrawal by investors from the stocks of the company as they cushion themselves from losses, thus diluting the price of the stock. It is important to understand that in the short-run, the company may end up having financial difficulties following the earnings announcements (Barnes, 2009, p. 46).

A company’s earnings announcement is also used by the business associates to measure the degree of the company’s creditworthy. Creditors would seek to be assured that the company will be able to meet obligations as they fall due, the already accumulated debts and also the ones to be advanced in the future. Any negative results may have reputation risks and financing problems as creditors may seek court injunction or withdraw from future relationships with the company. Such adversities will reduce the demand of the company’s stock leading to a reduction in its price in the market (Haslem, 2003, p. 163).

The earnings announcements portray a positive company performance which assures the investors the safety of their wealth. In addition, the announcement guarantees the stockholders of future benefits if they retain their investments in the company. Conversely, if the company fails to report any earnings, investors may transfer their investment to other attractive stocks in the market. However, these earning announcements have short term effect since the performance of the company in the long run may be affected by various economic factors such as market competition and recession among others. As the company’s output reduces due to these factors, the stockholders earnings will be lowered although the event might occur in the long-term and the net effect will be the decline in the company’s stocks price (Haslem, 2003, p. 164).

The investors will also take the earnings failure to imply that the company is being faced by some financial difficulties which denies safety of their invested capital. Companies should therefore make earnings announcements with a positive outlook, given that withdrawal of investors may have severe financial implications. The effect of this may be eroded demand of the stocks, thus a decline in the price of the stock.

Some manager believe that the stock market that focuses, in a minor way, on the short term earnings gives the company very small credit for long term earnings. However, looking at the high values for the companies that do not have any short term earnings, it was evident that market takes a long term view. A case study conducted on Sirius Satellite Radio showed that in September 2004, its market capitalization was about $4 billion. Yet at the same date Sirius had reported sales of only $30 million and on top of this there were more accounting losses. The reason for high valuation was because the investors of Sirius were optimistic that it would make significant profits at some moment in future (Koller, Goedhart, Wessels, Copeland, McKinsey, and Company, 2005, p. 78). The long term earnings did not work for many of these corporations. This has led to many executive complaining that markets are increasingly responsive to the short term earnings changes. As a result many firms are trying to respond to the short term earnings due to fear of not meeting the analysts’ anticipation. The effect is nevertheless short lived since the management can prove that the company is sound and that there is no need for its investors to worry. Such proofs are portrayed through increased future profits by the company; this shows that, stock prices respond greatly to private information signals and respond in smaller magnitude to public signals, for instance, positive return auto relationships may correspond to overreactions and thus long term correlation (Haslem, 2003, p. 163)

Since stock represent a fraction of business ownership, the stakeholders will always carefully and persistently concentrate on wealth maximization. The company may issue either of the two main types shares where each has different rules and privileges, common stock (ordinary shares) and preference stock. Basically, the common stock has voting rights but does not carry a guaranteed rate of return/dividend, unlike preference stock which has a fixed rate of return and is always rewarded before the common stock despite not having the voting rights. From the different classifications of the stocks, the holders will always appreciate any positive announcement of earnings, for instance, where a company reports a loss; the two groups of stakeholders stand a chance of losing their wealth and also fear of the future eventualities. Basically, an earnings announcement greatly helps in bettering and eradicating the future doubts of loss and minimized returns. Indeed, many investors running after short term benefits are more inclined to pay divided for fair values (Peterson, 2007, p. 216).

There are a number of tests for the efficiency of stock markets. The weak form efficiency shows that stock prices indicate the information contained in the times past of the former stock prices and commerce. In reference to this test, every day stock price alterations are independent hence not useful for investors who are trying to trace and exploit trends in stock prices. Here stock prices are random as well as volatile. Semi-strong form efficiency signifies that stock prices ought to show all publicly obtainable information. This should entail all economic information like inflation and GND growth, prospects and growth, earnings and balance sheets, and management. In reference to this test, stock prices respond swiftly to new disclosures. In strong form efficiency, stock prices show all the information even the one not available to the investors. This hypothesis is normally tested by looking at the returns earned by the organization executives and directors, who have more clear information than the investors as well as the community concerning the trades in their firm’s shares (Gray, Cusatis, and Woolridge, 1999, p. 195).

Conclusion

Stock prices are usually affected by a number of factors, one of them being the market forces. Subjectively, earnings announcement has a very big impact on the stock price fluctuations since the announcement tells more of the company performance. Whenever a company declares higher earnings to its stockholders, then it means that the company has had profitable operations during that specific year and from that perspective, the stock price of that company may increase as the demand continues to rise. On the other hand, when the company fails to announce earnings, then it means that the year never yielded much. There was either a loss or the amount which was earned cannot support the company’s budget and the payment of the earnings such as dividends. The effect is though short-term since earnings announcement does not necessarily mean that the company is operating smoothly. Other economic hardships such as loan repayments and other financial problems might have a continued impact on the company’s operations. From the hypothesis of an effective market, the statistical tests have shown that stock price changes are independent of the different day to day periods. These studies have shown that stock price changes over time are basically not dependent on the former price changes and cannot be used to forecast the forthcoming changes. There is need to look in details the existence of longer term cycles in the stock prices like seasonal or monthly cycles.

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