Understanding share price reaction to company announcements

Ever wondered why the share price of a company falls after a seemingly positive announcement?

Why would the share price fall 5% when the company announced it has increased its net profit by 20%?

Although the share price reaction does not seem logical, there is a very good reason for it.

The share price is influenced by a multitude of factors, but ultimately it is determined by demand and supply. If buyers are bidding for a larger quantity and willing to buy at a higher price than what is being offered in the market, the share price will be pushed up. Vice versa.

Investors buy and sell based not only on published facts, but also on rumours and expectations.

It is not uncommon to see a stock rise or fall before a formal announcement is made. Sometimes, material and price-sensitive information are "leaked out" of companies before the general public is made aware of the facts. Sometimes, certain events are predicted by analysts and people who follow a company very closely. Because these rumours and expectations are not yet confirmed by the company, they do tend to snowball to become overly optimistic or pessimistic, resulting in the stock being bidded up or sold down excessively. When the company finally makes an announcement that confirms or contradicts the initial rumour or expectation, the share price will adjust accordingly.

Let us look at a few scenarios where this could happen.

Scenario 1
- The rumour in the market is that Company XYZ is going to announce it has tripled its profit.
- The share price is bidded up to a valuation incorporating the rumoured profit level.
- When the company finally announces its profit figure, indicating that profit has grown 200% (which on face value, is a good news), the share price crashes.

Scenario 2
- Influential analysts from major brokerage houses expect Company ABC to suffer a 30% drop in net profit next year.
- The share is sold down to a valuation incorporating those expectations.
- When the company finally announces it expects its profit to drop 20% next year (which on face value, is a bad news), the share price bounces up.

Scenario 3
- Company 123 announced in its latest profit guidance that it expects profit to drop 50% in the following year.
- The share price is pushed down to a valuation incorporating the latest profit guidance.
- Analysts begin to build in a more serious profit downturn into their valuation models. The share is sold down further to reflect the lower valuation.
- One year later, the company announced that its profit has dropped 50%. The share price bounces back up.

Scenario 4
- Everyone knows that Company GGG is in financial strife. Revenues are falling and expenses are rising. The CEO is leaving.
- The share price is sold down as a result.
- When the company confirms the market rumours of falling profit, the share price shoots up. In the last paragraph of the announcement, it is mentioned that the company is talking to a few suitors about takeover offers for the company.

As you could see, announcements sometimes generate a share price response that is not consistent with the face-value message of the announcement. There is a reason for it.

If you do not follow a stock closely enough, are not reading the market pulse, or are not reading between the lines, you will not know the reason.

Switched-on investors keep themselves informed of the analysts' consensus and market expectations on shares they own or are thinking of buying. By doing so, they are able to quickly decipher the underlying message of a company announcement and make an intelligent prediction on how the share price will react.

Written by
Austin Hui, MBA CPA
Senior Investment Analyst

This article was first published in the November 2007 edition of TRADING DAY magazine http://www.tradingday.com.au . TRADING DAY is a free electronic magazine for Australian investors and traders. Subscribe online at http://www.tradingday.com.au .