Your first reaction might be, why does this happen? What is wrong with everyone? The company reported better profits than previously so why did the price drop?
The answer is, expectations of opportunity. The majority of investors believed that the company would do better than 5%. When it comes to stocks, investors are forward looking and build on expectations for the future. If investors believe the economy and profits are going to better than they are today, prices generally move upward in expectation that the stocks will be worth more in the future. The key becomes, how much more? Let’s use the example above in a simple format but, realizing that the stock market can present a sometimes overwhelming number of facts to consider. Investors expected the company to earn more than 5%.
We will use 10% in our example. With this expected increase in profitability, investor’s believed the company would be worth $110/share at some time in the future which is above the current $100/share. When investors heard that the earnings would only be 5%, not 10%, the value of the stock was less than the previously thought $110/share. Maybe the price should be closer to $105/share or $106/share, so the stock sold off to reflect the new, more realistic price.
In this case, the company was more profitable than before but, the price dropped today. Of course the question for the future becomes, what are the expectations for the future?
For every seller of a stock there is a buyer of the stock. Investors cannot just sell into thin air to anyone. The old saying that there were more sellers than buyers has always been and will remain -WRONG.
So, somebody was a buyer on the other side. Maybe this person was perfectly fine with the 5% increase in profitability and they believe the current price of $105/share is good value and maybe they believe the company will be better in the next few years and they are a more patient investor than those that sold today. This is why understanding your individual reasons and objectives for investing are very important and why the other person’s objectives are of less importance and can sometimes be misleading or confusing.
Don’t be mislead by thinking that investors are wrong, they just have different expectations.