Facebook stock ($META) dropped 25% overnight. Amazon ($AMZN) dropped 6% one day, then increased 12% the next day. Apple stock ($AAPL) went up 10% over a weekend. Just another week in the stock market.
Many people are asking, “How can such established companies grow or shrink by so much, so quickly? Surely this is a sign of manipulation!“
Let’s discuss. Let’s explain how stocks can rise or fall so much, so quickly.
How Are Stocks Valued?
Before we look into stocks getting instantly crushed, we need to determine how stocks are valued.
A stock represents fractional ownership of a company.
If I own one share of Apple, I own about one 16-billionth of the entire Apple corporation. I own that fraction of their facilities, their equipment, their unsold gadgets, their intellectual property. All of that stuff has value. I also own the responsibility of paying back Apple’s debts and liabilities. The difference between these assets and debts is Apple’s book value.
I also own a fraction of all of Apple’s profits. This year’s profits, next year’s profits, all the profits from now until kingdom come. Those future profits are all worth something today. We use a process called discounting to find the present value of those future profits. Analysts also attempt to predict how these profits will grow in the future.
Further reading: an explanation of how discounting works
All stocks—$FB, $AMZN, $AAPL, etc.—can be valued based on those two metrics: book value and discounted cash flow. A combination of the two leads to an intelligent estimate of a stock’s price.
What Changed Last Week?
Let’s think about Facebook, Amazon, and Apple. Did something change last week? Why the big swings?
Did their book values change? Their facilities, equipment, patents, technology? No. That stuff did not change.
Did their discounted cash flows change last week? Yes. Let’s talk about how and why.
All three companies reported their 2021 Quarter 4 earnings in the past two weeks. This is when they tell the stock market, “Here’s how we did for the past 90 days, and here’s our latest prediction of the near future.”
How did the companies perform? Did they meet expectations? Exceed them? Or fall short?
These earnings reports are vital. It’s how all stocks are valued. Analysts use both prior results and future expectations to assess the future discounted cash flow of the company. The DCF is then priced in to the stock price.
When a company’s quarterly performance exceeds prior expectations (called a “beat”), it’s a signal that future cash flows are also underestimated. The stock, therefore, is currently underpriced.
When a company underperforms (called a “miss”), it means that future cash flows are overestimated. The stock is currently overpriced.
(Take this with a grain of salt, of course. This is a simple explanation that’s generally true.)
This chart helps visualize the idea.
Beating prior predictions will shift the entire future earnings curve up. A miss will shift the entire curve down. A stock’s price is proportional to the area under the curve (e.g. the sum of all discounted future cash flows).
A small difference today can have a large ripple in the future.
Facebook, for example, reported last week that they missed earnings expectations by 4%. They also admitted that Apple’s recent iOS privacy change will lead to $10 billion in future missed revenue. Finally, Facebook reported that they lost daily users in Q4 2021 (begging the question – is Facebook still a growing company?)
As a result, Facebook’s stock immediately fell by 25%. Investors immediately assessed that Facebook’s future earnings curve shifted (significantly) down.
It’s not manipulation. It’s not voodoo. It’s an instantaneous reaction to recent news affecting how investors feel about the future.
But It’s Not Always 100% Rational
Sudden stock price changes are often grounded in rational thinking. But irrational emotions are at play too.
In other words, our friend Mr. Market is back.
Facebook missed earnings and its stock should drop. That’s rational.
But how much of last week’s 25% drop is explained by rational math? And how much is explained by irrational thinking like, “Facebook is dropping – sell, sell, sell!” Irrationality ripples many layers down. This is the so-called Keynesian beauty contest.
It’s impossible to say how much of a stock price change is rational or irrational. But both types of thinking are at play.
Falling Off for Today
Stocks suddenly rise or fall (or both) in reaction to quarterly/annual earnings reports.
When a company beats or misses its predictions, the market quickly reacts.
It’s not manipulation. Nor is the book value of the company changing. Instead, the market now believes that the company’s future is materially different than it believed before.
Different future, different stock price.