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How Expectations Influence Share Prices

Investors in the stock market would probably know that share prices are affected by a myriad of reasons, making it extremely tough to predict the direction of short-term price changes. Over years, however, share prices tend to converge towards the long-term growth in the earnings and cash flows of the underlying companies. In the short-term, all manner of news flows and psychological factors – such as sentiment – may influence the direction of share prices. Let us look at one pervasive influence – the role of expectations in moving share prices.

Has news been “priced in” yet?

We often hear this phrase when we browse through broker reports or listen to financial commentators. Pundits talk about whether certain pieces of news have been “priced in,” while analysts debate on exactly how much of certain news have been incorporated into the share price of a company. What exactly do they mean?

In the stock market, there are expectations for revenue and earnings growth of selected companies which are covered by brokerages and the financial media. These come in the form of projections made by analysts covering these companies, which are then referred to as the consensus estimate. This estimate encompasses the collective view on a company’s revenue and earnings performance from the analysts and brokers that are analyzing it.

To give an example, say there’s a large blue-chip company that is covered by 10 analysts. The average expectation from all of them is for a 10% increase in revenue and a 5% increase in net profit in the current year. Once this consensus estimate becomes public, investors would then bid up the share price of the company in anticipation of the good results. Pundits would then remark that the estimates of the analysts have now been “priced in,” implying that the share price of the blue-chip company now incorporates the information from the analysts.

Implications for investors

Why then are expectations important when investing? The risk here is that too much optimism may have been priced in, thus setting up high expectations for a company’s business growth when in fact, reality may be starkly different. If we as investors purchase shares in a company based on our belief that the consensus estimate is accurate, then we are at risk of seeing a sharp negative share price reaction should the company’s revenue and earnings rise less than expected, or even fall.

Examples of such phenomena are common in the stock market. Analysts may write glowing reports of a company which has been growing rapidly in both sales and profits, hence setting up high expectations for its future performance. Investors who chase the hype and buy into shares of such companies may get their hopes dashed when the company unexpectedly reports a fall in profits due to poorer than expected prospects. Once the optimism is removed from the company’s share price, financial gravity takes over and the share price plunges. This could cause permanent loss of capital for investors who bought during optimistic times as the company may then continue to struggle to recover lost ground.

The Foolish bottom line

It is important to understand the role of expectations when it comes to share prices, as a lot of good news may inadvertently have been priced in. Investors who invest recklessly may end up nursing sore wounds from their financial losses.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.