"expectations" question

[anvi]

As a permanent novice to economics and investing, I have a few general novice questions.  Pardon if these are stupid questions.  I actually make a living asking stupid questions, so get used to it.

It's not uncommon to hear news about a company whose profits came in under "expectations."  Given what is considered underperformance, the stock of the company often drops as people sell their shares, despite the fact that it's still profitable.

I guess my questions are: 1.) who is setting the expectations?  2.)  Why is, or should, a company be lampooned on Wall St., and subject to selloffs, even when it continues to make a profit?  Ok, sometimes a company may come in under what people think it should and sometimes it comes in over, but intuitively, I don't see anything necessarily unusual about that, unless the underperformance becomes a pattern and the company starts to absorb losses.  But if it continues to be profitable, I don't understand the logic of loss of confidence in it.

Can someone explain?  Thanks.

[Foucaulf]

There's probably two ways of answering this question: from a "long" perspective (holding the stock and wanting to earn a profit) and a "short" one (selling high and rebuying low).

From the long perspective, your expectations are set by stock prices alone. Talk about profits today from the company are well and good, but what is the reason to trust them, or the reason to believe profits will continue in the future? The best judgment of the intrinsic value of a company, according to some people, is the stock price; that one price aggregates all the information possessed by buyers and sellers trading in them. (This is a very stylised version of the "efficient markets hypothesis")

We may want to wish the company were profitable in the future. But it's a big "if"; there is so much uncertainty that we cannot digest. Faced with the uncertainty and perhaps a stock that looks on the rise, we may decide to shift our investment into what we see works.

From the short perspective, you always need a reason to hold on to a stock. To short is to take advantage of any overvaluation (some people, I guess, call this "beating the average" or "getting alpha"). If the stock faces a devaluation, the best strategy for you as a shorter is to get out now and exploit the peak.

And don't forget that another person has to accept the price you're willing to give for the stock - if the demand for stock is low and shorters are in great supply, that will drive the price down. Then you see everyone rushing for the door.

[anvi]

Thanks for that.  I guess I can see the short strategy.  But the long strategy strikes me as kind of dodgy--I mean, long term, any company might be sunk by another still-forming but currently unnoticed company or an unforeseen change in the industry and so on.  But, as noted, I'm a perpetual novice with these kinds of things.  Plus I guess logic doesn't play a huge role in an area where people are basically placing bets. 

[AggregateDemand]

The elementary equation for stock price valuation is current price + next year's dividend. Of course the market is much more complicated, but the elemental equations still highlights the importance of the dividend, which is earnings-per-share in the world of finance.

The companies give guidance about future earnings, and then Wall Street analysts at the major investment firms crunch numbers, and the composite or consensus value is often published by the investment media. During the business period (usually quarter), companies may revise their guidance or give cautions the public. Sometimes these cautions are overly pessimistic, and the firm misses earning by less than expectations, which actually sends the stock upward, despite falling short of analyst's earnings estimates.

Performance is becoming a big deal because many stocks no longer function like dividend yielding assets. Facebook, for instance, trades at about 100x earning (PE ratio), which means the actual return is around 1%. It's less than inflation, which means the company is trading entirely on expectations of future profits and stock demand. Amazon usually trades between 500x-1000x earnings. Netflix trades around 200x earnings. It's all contagion and stock demand trading. No real returns to speak of, which means expectations and hype must be satisfied.

[anvi]

It's all contagion and stock demand trading. No real returns to speak of, which means expectations and hype must be satisfied.

Thanks for the whole explanation, AD.  It's the latter part that always left me puzzled.  Even when the companies themselves provide numbers and speculation about the near future, the expectations and hype among investors become a sort of system unto itself. 

[Gustaf]

It's all contagion and stock demand trading. No real returns to speak of, which means expectations and hype must be satisfied.

Thanks for the whole explanation, AD.  It's the latter part that always left me puzzled.  Even when the companies themselves provide numbers and speculation about the near future, the expectations and hype among investors become a sort of system unto itself. 

Anvi, the basic reason is that the value of a stock depends on future profits of the company. If it's earning less than expected it can be seen as evidence that future profits will be lower than expected. Then the stock is worth less than before.

Note that it isn't binary. There is nothing contradictory in a company being profitable and its stock falling, since it isn't falling to 0. It's still worth something just not as much as you thought before.

[anvi]

Anvi, the basic reason is that the value of a stock depends on future profits of the company. If it's earning less than expected it can be seen as evidence that future profits will be lower than expected. Then the stock is worth less than before.

Note that it isn't binary. There is nothing contradictory in a company being profitable and its stock falling, since it isn't falling to 0. It's still worth something just not as much as you thought before.

Yes, I understand the non-binary nature of it.  But whose expectations?  Those of the investors?  What are their expectations based on?  How do investors know what future earnings are "supposed" to be given the inherent uncertainty about markets...and about the future in general?  And if a company doesn't perform up to expectations, is there any careful consideration or analysis of why it came in under them before its stock is sold?  Maybe in some cases, but I'm skeptical about whether the expectations process is altogether as rational as some might argue.

But maybe what I'm expressing, given my general ignorance about econ, is not so much an objection to the process as sympathy for some of its victims.  A company continues to make a profit but its stock falls.  Business is a damned tough beat. 

[AggregateDemand]

Yes, I understand the non-binary nature of it.  But whose expectations?  Those of the investors?  What are their expectations based on?  How do investors know what future earnings are "supposed" to be given the inherent uncertainty about markets...and about the future in general?  And if a company doesn't perform up to expectations, is there any careful consideration or analysis of why it came in under them before its stock is sold? Maybe in some cases, but I'm skeptical about whether the expectations process is altogether as rational as some might argue.

But maybe what I'm expressing, given my general ignorance about econ, is not so much an objection to the process as sympathy for some of its victims.  A company continues to make a profit but its stock falls.  Business is a damned tough beat. 

The same questions were asked over hundred years ago, and they were answered, imo, at the end of the 19th century by the theory of subjective value, a staple of the Austrian School of Economics. We don't really have a cardinal system of expectations. In other words, we cannot say with any degree of certainty that Company A should make a return of 5.5% annually based upon its financial statements. Humans use ordinal evaluations; instead. Company A should perform better than Company B should perform better than Company C, based on the attributes of each company. Stock price adjusts accordingly until investments with similar risk and growth potential reach P/E equilibrium.

Subjective value is more fluid and relies less on specific calculations, hence the existence of relatively simple calculation like ROA, ROE, current ratio, debt-equity, etc. If we achieve general consensus among investors as to the ordinal evaluation of investments, we can better understand the flow of capital between various investment instruments. If we have a general understanding of capital flows, and we have a system of benchmarking investments, we can make specific normative evaluations and earning projections about the financial performance companies "should" be achieving relative to other investments and historical performance. Obviously, the sticky wicket is risk assessment because risk perception varies widely amongst investors.

While it is true that stock price can fall despite positive earnings. It is also true that stock price can rise based upon structural improvement, like price leverage or competitive advantage, even if earnings never materialize. Just a strategic product announcement can change the fortune of a stock, even if the returns do not materialize for years.

[Gustaf]

Anvi, the basic reason is that the value of a stock depends on future profits of the company. If it's earning less than expected it can be seen as evidence that future profits will be lower than expected. Then the stock is worth less than before.

Note that it isn't binary. There is nothing contradictory in a company being profitable and its stock falling, since it isn't falling to 0. It's still worth something just not as much as you thought before.

Yes, I understand the non-binary nature of it.  But whose expectations?  Those of the investors?  What are their expectations based on?  How do investors know what future earnings are "supposed" to be given the inherent uncertainty about markets...and about the future in general?  And if a company doesn't perform up to expectations, is there any careful consideration or analysis of why it came in under them before its stock is sold?  Maybe in some cases, but I'm skeptical about whether the expectations process is altogether as rational as some might argue.

But maybe what I'm expressing, given my general ignorance about econ, is not so much an objection to the process as sympathy for some of its victims.  A company continues to make a profit but its stock falls.  Business is a damned tough beat. 

Yes, the investors invest based on their expectations. They base that on the best analysis they can provide. Which of course is not perfect, but they do pay some pretty smart people to work very hard at those.

That we do not know the future perfectly is the reason why stock prices fluctuate. If a company reports a profit that was below expectations it may be a sign that expectations on the future were also inflated.

Note, there is not really a "supposed". There is just the analysis people make. Think of it as a political race. Let's say that you think Vermont is D+15 in a presidential election. Let's say you expect the D candidate to win  52-48, so D+4 nationally. Let's say Vermont gets called as D+10 early in the night. Based on your expectation (which was based on your analysis of the polls, racial breakdowns, issues, etc) this is bad news for the D candidate. Sure, they won a state but they won it below expectations and you might think that an underperformance of 5% on the margin will translate nationally into a 1 point loss nationally.

Not sure if that made it more or less comprehensible but at least I tried.

[anvi]

It's very helpful, Gustaf, thanks!