I learned about the stock market through a story on National Student Marketing Corporation (NSMC), a high flyer in the 1960’s. Wall Street fell in love with stock and valued it 20 times above its initial public offering price.

The story was that NSMC’s growth would be phenomenal. It was on acquisition spree and used its stock to buy companies. Since the company used its stock to buy companies, they have every reason why they need to increase their share price.

A good way to increase their share price is to report higher earnings every quarter.  Every quarter, Wall Street cheered on as management consistently reported better than expected earnings. After a series of investigation, the Securities and Exchange Commission concluded that the management was guilty of fraud and earnings manipulation.

It was a good lesson on investor vigilance and skepticism, but it gave me enough reason to study how stock prices move.

You may wonder why share prices move higher when a company reports higher quarterly earnings. Are investors short-sighted?

There are two principles to explain this:

  1. The stock represents an ownership in a business. An investor’s fortune is directly correlated to the company’s performance;
  2. Stock prices are set of expectations of the company’s future business performance.

The second principle is very important. The keywords here are expectations and future performance.

Last year, the news of the oil spill was all over the headlines. The result was BP’s stock price hit a new 52-week low. Investors anticipated a big loss from clean-up and lawsuits, which mean lower earnings in the future.

Here’s another recent example. In the global financial crisis of 2008, investors sold banking stocks indiscriminately. Investors expected lower future earnings from the massive write-off of toxic assets. Moreover, they also expected that some of the smaller banks would go into bankruptcy.

The task of an investor is to evaluate what the stock price implies and compare it to its probable long-term financial performance of the company. For instance, a retailer reported a lower than expected earnings for the quarter. As a result, the stock price languished.   

A keen investor would then look at the retailer closely and analyze whether the lower quarterly earnings reflects a long-term business problem. If the company’s business model and long-term prospects remain intact, the stock offers a buying opportunity.

If the investor can consistently anticipate changes in expectations, he’ll be on his way to generating superior returns over a long period of time. 

Stock prices reflect expectations