0. What is this Post about?

Did you ever wonder why the stock price of a company drops, just after the company announces a stellar quarterly earnings report? And this happens more often than not. At first, this looks unnatural. A growing company, announcing a double digit growth Year over Year (YoY), should be rewarded by an increase in its stock price. After all, that is the reason why investors invest in a company’s stock – to make gains as the company grows its revenue, resulting in growth in the company’s stock price. In this post, I will lay down some reasons behind stock price fall after a company announces fantastic results. I will also share my suggestions on how investors should act on this price drop. Let’s get started.

1. Reasons for Stock Price Drop after announcing good results

There are many reasons for a company’s share price to go down, immediately after it announces good quarterly results. Some of them are mentioned below.

1.1 Bleak Near Term Outlook

Even though a company’s current quarter results are fantastic, the near term future can be bleak. Example is Q4′2021 earnings release of Divis Labs – a bluechip Indian Stock in specialty chemicals space. Divis Labs announced fantastic Q4 2021 quarter results. Its profits soared 78% YoY (year over year), and revenue climbed 41% YoY (article link). This outcome even beat analysts’ estimates. However, post the results release, Divis Labs share price tanked 20%, falling from INR 4,304 to INR 3,448 over two trading days. Why? Divis Labs Covid related revenue was now expected to go away\. This removal of covid related revenue will negatively impact the next few quarters revenue growth of the company.

As is said, the stock market is the collective intelligence of all of the market participants. And the market saw the weakening of Covid at the start of Q1′2022 FY. Hence, the market predicted the negative revenue impact on companies such as Divis Labs, causing the company’s share price to drop. Stock market is a forward looking voting machine in the short run, and embodies the future growth visibility of a company in its stock price.

1.2 Profit Booking

Majority of investors in the stock market are there to make money. And money is made by selling stocks. If a stock has run up quite a lot, and that too for a long time. And then the company announces great results – this might trigger investors to do the thing they are there to do in the stock market – make money. These investors will sell stocks and book profit. It is common knowledge that each stock has good times, and bad times.

It is only common to book profits during the good times of a stock. Or when the good times have lasted too long – signaling a probable end to the good times being around the corner :-). As it is nearly impossible to time the market, investors book profits after seeing a decent upside in the price of a stock.

1.3 When Good Results are not Good Enough

Sometimes, when a company announces good results, these results are just not good enough. Confused? I was too, when I read articles stating that company X showed double digit growth year over year, but fell short of analysts’ estimates. Yes, you read it right. Analysts’ estimate the future earnings of a company. These estimates include revenue growth, profit growth, operating margins. Analysts make these estimates by studying the macroeconomic environment, using the company’s management growth guidance, and doing their own research around competition, demand trends etc.

But what is important, is to understand the influence of these analysts’ estimates on the company’s share price. There is a lot of impact. Analysts’ estimates are publicly available. Analysts give interviews in newspapers, news channels on their recommended stocks, and the % upside or downside they estimate. Many stock research sites provide paid memberships for accessing these analysts’ reports.

Over time, popular analysts employed by reputed brokerage houses gain reputation. Majority of investors buy and sell stocks based on these analysts’ recommendations. In a nutshell, analysts’ estimate of a company’s future growth has a significant impact on the investors’ sentiments, which trigger buy and sell decisions. You can guess what happens when a bunch of investors who bought a stock hoping for 20% increase in revenue as per analysts’ estimates, but only got 18% growth in revenue. These investors sell!

Example: India’s largest IT company – TCS (Tata Consultancy Services), posted great results in Q1′2022 (news link here). Revenues grew by 16.2% YoY. However the stock price declined by 8% within two trading sessions of results release. This was driven by analysts’ estimate of earnings per share (EPS) being missed. EPS miss was in turn driven by margin pressure on the company’s operations.

1.4 Macro economic factors

Sometimes, a company’s share price decrease is not related to the company at all, but to the macro economic factors. Example, when Russia declared war on Ukraine in Feb 2022, the entire Indian Stock market tanked by 2.5% in a single day. It does not matter if a company declared good results on this day. The company’s share price will fall with the entire market.

There can be numerous other macroeconomic factors negatively impacting the price of a company, and the overall market. Example: When Covid 19 broke out, causing lockdowns across countries, or when the central bank of a country raises interest rate – signaling future demand constriction in the country etc. Negative macroeconomic events negatively impact all companies. The extent of impact can differ from one company to the other, but there is an impact.

1.5 Visible Headwinds to the company or the industry

Market is forward looking. It takes into account what is about to come. There can be visible headwinds which will negatively impact a company’s future growth, causing the share price to drop. Example: Increase in raw material prices. This can reduce margins of a company. Rising coal prices cause a decrease in prices of cement companies’ shares, who use coal as raw material. Similarly rise in crude oil prices causes fall in share prices of specialty companies who use some form of crude oil as raw material.

Headwinds can cause demand slowdown, supply constraints, regulatory hurdles, competition pressure leading to price wars etc. Sometimes, resignation of a reputed top management of a company can also cause investors to lose confidence in the company’s near term future, causing its share price to drop. These factors, unrelated to the company’s current performance, cause the share price to drop.

2. What should retail investors do?

Expecting a profit after fantastic company results, and then seeing price drop is not a good feeling. Investors might feel confused, annoyed, jittery. You may start questioning the quality of the company you invested in. You will start searching online for any news or article which explains the price dip in the company. Sometimes, you may find such an article, many times, you will not. So, what do you do?

One thing you must never do is to sell. When you buy a good quality company, you would have done your research of the company’s fundamentals. Your expectation from the investment in the stock would be clear. Either it will be a short term trade to make profit, or a long term investment. Let us see how a retail investor should act in the situation when stock price dips after a company announces good results.

2.1 I invested for short term profit

If you invested in a stock expecting good results from a company, resulting in stock price increase and making profit from it, you are certainly disappointed. I am assuming short term means less than a year. If this is your situation, you should evaluate the reason behind the stock price fall.

If the stock price fell because the company’s results fell short of analyst expectations, then you should stay invested. The stock price will usually correct, and go up in 2-3 months. This is because the stock price will catch up to the increased earnings, to maintain the price to earnings multiple allotted by the market to the stock.

However, if there are macroeconomic headwinds which cause the stock price to dip, then you should evaluate the time horizon till which these headwinds will last. If these headwinds are expected to go away in a couple of months, then you should stay invested, even invest more on this dip. Some examples of short term headwinds are supply ramp up delays, diversion of raw material supply delays, high attrition etc. These types of headwinds can be mitigated by the company in 2-3 months. 

If the headwinds will last more than one quarter, and the company management does not share an end date to these headwinds, you can consider exiting. These are signs of long term headwinds, which go outside the control of influence of the company. Example: Russia Ukraine War, regulatory interventions, cancelling of manufacturing license of a product etc. Do make sure that before you exit, you have other better investment opportunities.

2.2 I Invested for the Long Term

If you invested for the long term, you would have researched the company well. The company you invested in typically is fundamentally strong, run by experienced leadership, and has solid future growth plans. If this is the case, then you should buy the dip. The reason being, with increase in earnings, if the price drops, this means that the price to earnings multiple (PE) of the stock dropped. You can buy this dip, as the PE will come back to the historical average PE allocated by the market to the stock. This will happen as long as the growth story of the company remains intact.

Before buying more, you should research the reason behind the price dip. This is to make sure that as an investor, you are not overlooking a valid reason behind price drop. If not, then you can invest more with confidence. However, if in your research you find news which weakens the fundamentals of the company, you may want to consider holding further investment.

2.3 I only took a tracking position in the stock

Many investors invest a little amount in a stock in order to track the company. If this is you, then you should not worry, as your investment in this stock is small. You can use this opportunity to research more on the company. If you like this company, and become convinced of its future growth strategy, then you can actually buy the dip. 

However if you find the company to be too volatile to your taste, and are not finding enough conviction to hold on to the stock, then exit.

3. Parting Thoughts

As you have seen, sometimes the outcome (share price), is not in your hands. At times, even by showing good results, you do not get the desired outcome. Such is life. We should do what is within our control, and let our moody friend Mr Market do its thing – rewarding patience and penalising emotional investing.

Do note that this answer is not a comprehensive list of reasons for a company’s share price drop after posting good results. This is a list which covers the cases I have experienced in my investing journey. This list is to help you to get thinking, and uncover the story behind a stock price’s movement. Unravelling this story is what makes stock market investing alive, and interesting.

Did you also experience a similar event, when a company posted great results and then its stock price dropped? If yes, do share what you think was the reason behind the price drop.

Happy Investing !

Note: This post is an extended version of my answer to a similar question on quora here.