Why do stock prices plummet if earnings dip slightly?

I delayed addressing this topic until we’d been through a bit of a numbers-fest!  I talked earlier about money managers.  In many cases, money managers have models for the financial performance of companies.  Just as we will do in chapters 2 through 5, the models seek to learn the future, often using information learned from behavior in the past.  These models are based on earnings or more likely free cash flow.  In summary, free cash flow is the amount of cash you could extract from the business each accounting period without affecting its operations.

Now, the models call for a few things, but the most important thing is a growth rate for the free cash flow (which is tied to growth in earnings) and some kind of discount rate.  Free cash flows are discounted.  In other words, thanks to inflation, if you had a choice between receiving $100 to day and $100 a year from now, most people would want the cash now.  A hundred dollars will probably have less buying power a year from now due to inflation.  People have investing choices.  If government bonds pay 7%, then the company would have to beat that, since there’s no risk with government bonds.  Some discount rate is chosen to take all these sorts of things into consideration.  A terminal value is also selected—the calculation does not normally extend beyond five years.  In this example, the terminal value is added to the figure in year 5; the number is discounted back for five years at 15% each year.

Let me give you a wacky example.  It’s 1990 and let’s say a company is growing in earnings at 20% per year.  The company has earnings of $1 per share.  It has free cash flow of $2 per share.  The company is expected to report $1.20 per share in earnings and $2.40 in free cash flow. 

Free Cash Flow for a Fictitious Company

The cash flows are discounted at 15% per year.  In other words, the middle line is what the cash flow is projected to be; the bottom line is the cash flow expressed in terms of today’s (the start of 1990) dollars—money in the hand today!  A terminal, ending, value is selected.  The discounted free cash flows are summed to get a value—$21.28 in this example.

Now, let’s say that the company reports earnings that are just 2¢ shy of expectations.  In other words, instead of growing at 20%, earnings grew at 18%.  This new growth rate would be used to figure out the growth in cash flows into the future.  Here goes.

 Free Cash Flow for a Fictitious Company after Earnings Growth Expectations Drop by Two Percentage Points

The cash flows are still discounted at 15%.  The new value ascribed to the company is $19.91.  In other words, if there is a shortfall in earnings of just 2 pennies, this model would trigger an instantaneous drop in share price from $21.28 to $19.91, that’s $1.37 per share.  If the company had one billion shares outstanding, the 2¢ shortfall in earnings would wipe out $1.37 billion in company value.  Financial models related to the highly stylized one illustrated above are used widely on Wall Street.  The use of these models accounts, in parts, for sudden drop in share prices when earnings and short fall is announced.

The Federal Reserve also plays a role in share price valuations!  If interest rates are increased from say 5% 5.25%, the discount rate used in the free cash flow model would also increase.

Let’s say that the company does announce earnings as expected, but this announcement happens on the day that the Federal Reserve increases rates from 5 to 5¼%.  The increase of quarter of one percentage point.  However, 5.25 is 1.05 times as large as 5.00.  The rate increase causes the discounting factor to increase from 15% to 15.75%.  Here’s the effect.

 Free Cash Flow for a Fictitious Company after the Discount Rate is Changed

The new share price would be $20.54.  The drop is not as dramatic as the last example; however, the point is illustrated.  If there are changes in either growth rates or interest rates, share prices are affected.  These changes usually don’t seriously affect the business operations of a growth company.  They do affect what some people think such companies should be worth!

The takehome lesson here is that if a discount free cash flow model is used to value a share of a company, then it is very sensitive to things like earnings expectations and external factors such as interest rates.  Even though nothing else changes, stock prices can decline if a company announces a slowdown in growth; the share price may soar if earnings expectations are exceeded.  Similarly, the actions of entities such as the Federal Reserve could influence the price of shares traded on public markets.