Question

If the public expects a listed company’s earnings to be $10 per share this quarter and it actually earns $8 per share, the strongest earnings ever announced, what does the efficient markets hypothesis tell us will happen to the price of the stock when the $8 earnings are announced?

Answer 1

The stock prices in a market is a variable of supply and demand parameters. More the demand, more the prices and vice versa. The demand of any stock depends upon the future expected returns the stock will produce to the investor. If the market expects a stock to increase its retuns by say10%, its impact can be seen on the prices of the stock accordingly.

The efficient market hypothesis also known as the efficient market theory, is a hypothesis that states that share prices reflect all information in the market. You can never outperform the market based on any information as it already absorves all information in real time.

According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. The only way an investor can obtain higher returns is by purchasing riskier investments.

Thus if in our case, If the public expects a listed company’s earnings to be $10 per share this quarter, the market has already absorbed the news of a $10 return and its current prices would reflect an earning expectation of $10. However when the actual earnings are found to be lower say $8, it is very much likely that the price would show a correction and the prices of the stock would fall accordingly no matter if it would be the strongest earnings ever announced as the market is already expecting a $10 return and priced accordingly.