Stock prices are not determined solely by the content of an announcement. The key is how to interpret the difference between market expectations and actual results. The author explains how to quantify what is already priced in and analyze changes at a company separately from changes in market expectations.
This article argues that quantifying and interpreting the concept of what is already priced in can help inform investment decisions. It explains that even an announcement of positive news will not lift a stock if it fails to exceed market expectations, while a stock may react to negative news if it is not as bad as the market expected.
Stock price movements are determined not only by the facts in the earnings results themselves, but also by their deviation from market expectations before the announcement. The extent to which the results exceed or fall short of the level anticipated by the market determines the reaction.
The article proposes a two-layer model that considers “changes at a company” separately from “changes in market expectations.” It measures the company’s current position using revenue, margins, growth rates, capital efficiency, cash flow and other metrics, then works backward to determine how high expectations are and assess whether the stock price is justified.
By working backward from the growth rates and margins required to justify the current stock price, the gap between future expectations and their feasibility can be viewed as an “expectation gap.” A positive gap may indicate that the market is undervaluing the company, while a negative gap may indicate overvaluation.