My company made a profit, why did their share price fall?

Photo of Michael Kemp By Michael Kemp

min read

Understand why some companies predict their financial results, and others do not.

The forces that move share prices are not always obvious. Sometimes news of a profit bigger than last year’s causes a company’s share price to soar, and sometimes it falls.

This apparent contradiction can confuse investors new to the sharemarket. The direction the share price is likely to swing becomes clearer when you appreciates how shares are priced – they dance to a never-ending tune of investor expectations.

If the general expectation is for a company to deliver a significantly larger profit, but instead it delivers only a moderately larger one, the price often falls. But even a modest profit rise can make the price soar if the expectation was for a flat or negative result.

Which raises the question: should companies be flagging to the market the magnitude of soon-to-be-announced earnings results? Clearly companies develop a feel for what the result will be as they tally the figures. And there is no doubt that the important principles of market fairness and efficiency rely on all market participants being well informed in a timely manner.

This article focuses on what and why investors are typically told before a profit announcement and whether the information given measures up – this is called “earnings guidance”.

What is earnings guidance?

Earnings guidance is simply a listed company’s prediction of its financial result.

There is no blanket legislation that requires companies to issue guidance, even though there is a misconception among some investors that there is. Yet many companies choose to do so.

However, there are circumstances where legislation does require a company to issue profit guidance: when the ASX’s continuous disclosure requirements are triggered.

Continuous disclosure requirements

ASX Listing Rule 3.1 is succinct. It states that: “Once an entity is or becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity’s securities, the entity must immediately tell ASX that information.”

This rule applies to any event, at any time, that could have a material effect on a company’s share price and is not limited to an unexpected financial result. It could relate to the discovery of a rich new seam of gold for a mining company or an impending class action against a payday lender.

But clearly, it also applies when a company first realises that an upcoming profit result will vary materially from the market’s expectation. The company would be obligated to issue earnings guidance.

You might expect that brief ASX Listing Rules, such as 3.1 and its associated 3.1A and 3.1B, would be fairly easy to interpret, especially as statutory continuous disclosure requirements have been in place in Australia for more than 20 years. But that has not been the case. So in order to clarify their interpretation, ASX recently released an updated Guidance Note 8 specific to continuous disclosure. It is 84 pages long.
We can focus on just three important points that are specific to this article:

  1. There is no general obligation for listed entities to provide earnings guidance to the market or to release their internal budgets or earnings projections.
  2. A company has a legal obligation to notify the market if it becomes aware that its earnings for the current reporting period will differ (downwards or upwards) from market expectations to such magnitude that a reasonable person would expect it to have a material effect on the price or value of the entity’s securities.
  3. The guidance figures delivered by the company cannot be based on an estimate or a rough forecast. They must be based on reliable information.

How market expectations are determined

Of course, this raises a very important point: how does a company determine what the market is expecting its earnings for the current reporting period will be? The Guidance Note covers this issue:

“ASX considers that the best and most appropriate base guide to use for these purposes is:

  • if an entity has published earnings guidance for the current period, that guidance;
  • if an entity has not published earnings guidance for the current reporting period and it is covered by sell-side analysts, the earnings forecasts of those analysts; and
  • if an entity has not published earnings guidance for the current reporting period and it is not covered by sell-side analysts, its earnings for the prior corresponding period.”

It finishes by adding: “Each of these measures is only a guide to what the market is expecting.”

What is meant by “material effect”

Guidance Note 8 advises that a company has a legal obligation to notify the market if it expects its earnings for the current reporting period will have a material effect on the price or value of the entity’s securities.

As for what is meant by a material effect, ASX distinguishes between the position for entities that do or do not publish earnings guidance.

For those that do, it recommends updating that guidance if the company expects a material difference between its actual or projected earnings for a period and its published guidance for that period, and that Australian Accounting Standards materiality guidance be applied; that is:

  • A variation of more than 10 per cent should be treated as material and entities should presume guidance requires updating; and
  • A variation of less than 5 per cent should be treated as not being material and entities should presume guidance does not require updating.

Unless, in either case, there is evidence of a convincing argument to the contrary.

Entities which do not publish guidance need to consider whether the variation to market expectations is market sensitive. That is, disclosure is not expected merely because there is a 5 to 10 per cent variation between actual or projected earnings and market expectations.

Why issue guidance if not necessary?

If an upcoming profit result is unlikely to materially effect the share price, a company is not obligated to issue guidance. So why do many do so anyway?

It’s an interesting question, even more so when put in historical context.

In my forthcoming book, UnCommon Sense, I describe the culture that prevailed in US boardrooms more than a century ago. Many companies were reluctant to provide any form of financial results to the market.

Author Louis Guenther described this attitude when he wrote that the representative of one US company complained that financial reports were unnecessary, because in making their affairs known, companies would “lay their trade secrets before competitors”.

Of course, attitudes regarding disclosure have changed, but the question remains, why do companies issue guidance when they aren’t required to? Commonly stated reasons are that it results in:

  • Lower share price volatility.
  • Improved liquidity in the stock.
  • Reduced information asymmetry (a complex way of saying that it helps align investors' views regarding the stock).
  • Delivers a lower cost of capital.

Two commonly stated disadvantages are:

  • The time and cost involved in providing disclosure.
  • It introduces an emphasis on short-term earnings targets, fostering myopic managerial behaviour that is detrimental to a firm’s long-term growth and value creation.

As for the stated advantages, there are as many studies supporting them as there are discrediting them.

The bottom line

The ASX approach to earnings guidance – that it is important in facilitating a better-informed market – makes pure sense. But evidence is thin that there are advantages beyond this.

There appears to be little advantage in making guidance mandatory. It is important to remember that stock valuation requires a long-term view, not a short-term one. To enforce a blanket requirement could encourage short-termism and introduce a game where managements display short-term targets, which are then used by investors to make short-term judgments.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint and author of the upcoming book, Uncommon Sense: Investment Wisdom since the Stock Market’s Dawn, published by Wiley.

From ASX

Watch this video from ASX on Continuous Disclosure and an explanation of Guidance Note 8.


The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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