This is one of a series of articles, Covering Financials, focused on financial accounting disclosures and how you as a journalist can interpret and report on them. The first four articles (see related links) introduce the financial accounting concepts utilized in this and future articles. If you have a topic you are interested in, post your request in the comments or email me at email@example.com.
Have You Noticed that Earnings and Stock Prices Often Don’t Move Together?
It is common for public entities to announce positive earnings, growth in earnings and other financial-statement-related news that on the surface appears to be good news. Yet, those entities’ stock prices don’t always increase. Sometimes they decline on the apparent good news. Statements such as “stock price declined because the market expected more earnings” or, “the quality of earnings was lower than expected” are common. But where do market expectations come from? The relationship between earnings and stock price is not simple.
Finance Theory as a Guide
Modern finance theory emphasizes financial performance relative to market expectations as a leading cause of stock price changes. The idea is that investors always have the option to invest in the market. Management teams that generate financial performances better than the market experience stock price increases relative to the market. Many investors subscribe to this notion and attempt to invest in entities they think will outperform the market. Of course, stock prices rise and fall with overall market expectations too, but many investors don’t focus on overall market changes because they stay fully invested in the market itself. As a journalist, you might want to focus primarily on financial performance relative to market expectations because relative results are generally under managers’ control. They have little control over market-wide factors. Some of the most interesting financial topics focus on how managers either create value or destroy value relative to the market.
As you think about this idea, consider how seldom managers announce earnings in relation to market expectations. Instead, they announce earnings relative to past years or past quarters, making statements such as “earnings increased 10 percent” or something similar, with no reference to market expectations. In terms of finance theory, these sorts of announcements are incomplete thoughts. A little journalistic investigating could yield interesting articles for your readers. Let’s explore framing earnings announcements in terms of market expectations in a little more detail.
What are expected earnings? According to finance theory, they are the amount of wealth invested at the beginning of an accounting period (quarters or years for U.S. public entities) multiplied by the cost of equity capital. The cost of equity capital is the market’s expected return to equity investors for a given level of risk. This idea is more intuitive than it first might appear. Consider a risky investment, such as most Silicon Valley high-tech investments. The investment risk is high because there is a high probability of failure, so the cost of equity capital for these investments is also quite high, perhaps 20 percent or more. No one invests in high-tech enterprises expecting a steady, low-risk return. Also intuitively, many entities make investments that are far less risky. A manufacturing firm designing a new product in response to customer demand, where the product is similar to products it already sells, probably isn’t taking much investment risk. Cost of equity capital would likely be much lower than a Silicon Valley high-tech investment, perhaps only 10 percent.
The point is that this framework is useful when assessing managers’ earnings announcements. When managers announce “earnings increased 10 percent over last quarter” you will want to investigate beyond their comparisons to prior quarters, asking and assessing: 1) did the amount of investment increase, decrease or stay the same; and 2) did risk (cost of equity capital) increase, decrease or stay the same.
While a statement such as “earnings increased 10 percent” initially looks good, obviously if investment doubled but earnings only increased 10 percent, well, that doesn’t look like good performance anymore. Alternately, if an entity increased earnings 10 percent while substantially decreasing the amount invested, that same “earnings increased 10 percent” statement could represent superior performance. Likewise, if investment risk increased substantially, then a 10 percent increase in earnings may also represent poor performance.
Applications of finance theory offer mathematical and statistical methods to estimate both investment amount and cost of equity capital. Valuation models such as the discounted cash flow model and the residual income model help frame and evaluate financial performance. These models are technical in nature, and you may want to ask market professionals for their estimates of investment and cost of equity capital (and perhaps explanations of their models). Security analysts, mutual fund and hedge fund analysts, services such as Value Line, investment managers and other investors often are willing to share their analyses, or at least share the results of their analyses.
Once you have quantified market expectations, ask managers to assess their performances relative to market expectations. In my experience reading earnings announcements and working with managers, you may not receive a satisfactory answer, but that in and of itself may be the start of an interesting article topic. Many managers want to shy away from explicit comparisons to market expectations, perhaps because they can be quite lofty. Oh, and they may want to take credit for market-wide or industry-wide stock price increases unrelated to their own efforts.
Steven Orpurt is a professor teaching corporate governance and sustainability in the W.P. Carey School of Business at Arizona State University.