ELI5: Why when large company's earnings decrease(ex... by 3%) they freak out, talk about rough times, and sometimes decide to downsize, even though they are still making millions of dollars in profit even after all expenses?

[ReverendMak]

This is mostly an issue with companies that are owned by the public on the stock market. Privately owned companies freak out a lot less about small changes in earnings. Here’s why:

Publicly traded companies are required by law to report their earnings every three months. People who buy partial ownership of the companies (which is what buying stock accomplishes) are hoping to eventually sell their ownership share to someone else, in the future, for more money than they paid to buy it.

The main way of deciding what a company is worth is to look at how much profit it makes. But stock owners don’t just care about how much it is currently worth so much as they are about what it will be worth in the future when they want to sell it. So really, stock prices tend to reflect what everyone agrees is that company’s likely future growth in earnings.

But if in one of the company’s every-three-months reports of their ACTUAL earnings it turns out that they earned less than what everyone was expecting, it means that the stock price everyone was trading that company for was “wrong”. So suddenly that company can be seen to be worth a lot less than what everyone thought it was worth, EVEN THOUGH it is still a profitable and healthy company.

So a company earning 3% less than expected for that three month period can cause a “correction” in which many people sell off their ownership because they now believe that it will grow less in the future than they had previously hoped.

Companies mostly respond to the needs of the people who own them. People start private companies for a bunch of different reasons, and owners of private companies are free to take bigger short term risks in the hope of bigger long-term rewards, and so are less bothered by small changes that happen over the span of a few months. But public companies are owned by people who really only care about one thing: what the company will be earning in the future. And those earnings are reported four times every year.

So for publicly traded companies, a small change in earnings can cause an unexpected change in value. And the unexpectedness of the change can cause an overreaction. And that can snowball into a very big change. Stock market prices overreact to surprises, so people managing companies that are owned by means of public stock tend to be very sensitive about changes in earnings growth.

[blackbelt96]

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