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For instance, how do the earnings of a company affect its stock prices?

Earnings reports increase a company’s chances of experiencing a rise in price or value of the company’s stock. This is because companies’ earnings are one of the big factors that affect or determine that value of companies’ stocks/share prices. If a company’s earnings or profits are increasing in a financial year, there is a big chance that the value or price of that company’s shares will also increase because the company is performing well. But if the company’s earnings are reducing, there will be a reduction in the share price or value of a company’s stock/shares because the company is incurring or has incurred losses in a financial year.

Secondly, a company’s earnings can affect the demand for a company’s shares. This is because investors want to invest in companies that they are sure have the potential to generate good returns on investments. No investor will want to invest in a business where he/she is not sure of making profits. If a company performs well and is earning high profit levels, there will be a high demand for that company’s shares on the stock exchange as investors want to invest in stocks or companies whose stocks perform very well since as there will be guarantee of good returns on investment and once the demand for a company’s shares is high, there will be a rise or increase in the company’s share prices since factors of demand and supply are among the factors that affect a company’s share prices. But if a company’s earnings are low, there will be less demand for that company’s shares as investors will not have confidence in that stock’s ability to bring good returns on investment which will result in the fall in the company’s share prices.

Determinant of investor confidence

If an analytical comparison of a company’s past and present earnings reveals an improvement in the company’s fundamentals, investor confidence in that company goes up. Similarly, if the comparison shows a decline, investor confidence also declines.

However, it must be noted that there is an element of unpredictability to this assertion. For instance, if a company’s earnings improve by a margin lower than was expected, investor confidence may drop.

How stock prices respond

Since stock trading is largely speculative, investor confidence or market expectation have a significant impact on the movement of stock prices. If investors are confident that a company’s performance will continue to improve, the demand for that company’s stock goes up.

This high demand then stimulates an increase in the prices of the company’s stock until equilibrium between the incentive to buy and sell is achieved. On the other hand, if an analysis of the entity’s earnings predicts a downward trend, demand for stock falls.

Correspondingly, the stock prices fall and shareholders rush to sell their shares. In this way, the earnings of companies affect stock prices and result in market movements as per investor expectations.

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Price-Earnings Ratio

Due to the correlation between earnings and stock prices, there is a documented metric used to express the relationship between the two variables. This metric is a ratio known as the price-earnings ratio alternatively called the P/E ratio.

The P/E ratio is obtained by dividing the price of a share by the yearly earnings per share of a company. Essentially, P/E ratios express “how much investors are willing to pay for $1 of a company’s earnings.”

Therefore, if a company’s P/E ratio is high, it shows that investor confidence is high and expectations are that earnings will increase in future. A low P/E ratio on the other hand indicates that a company’s stock is undervalued because investors want to pay lower for earnings per share.

Market reactions

Another way to play this game is to trade stocks that are often followed by institutional investors, who are highly sensitive to quarterly earnings reports. In a simple regression modelling exercise, we find that the movement of stocks with market capitalization of at least P95 billion have high correlation of 54.6 percent with earnings announcements while stocks with P60 billion and below has correlation of only 23 percent.

Conclusion

It should be noted that earnings can in no way be considered a perfect indicator of a company’s future financial performance. Rather, earnings are just useful in observing an entity’s performance trend and in conjunction with other indicators, making investment decisions.