Understanding the Market » Blog Archive » Why GE stock fell so much on Friday April 11

Why GE stock fell so much on Friday April 11

Last Friday (April 11), General Electric Corp (GE) announced that quarterly earnings were $0.43 per share, or about $4.3 billion. This would seem to be fairly good news; the number was down a bit from profits a year ago, when quarterly earnings were $0.44. Yet the \stock price dropped by almost 13%; largely in response to this news , the rest of the market dropped by 2% (see here for a typical newspaper story).

Why does a stock fall so sharply on what would seem to be not so bad news? The answer has to do with the market’s expectations for GE , and GE’s past aggressive use of a tactic known as “earnings management”. (Disclaimer: I am not an accountant and have never actually analyzed GE’s accounting statements. I own a bit of GE stock through investments in broad market indices. This essay, like all essays on this site is not to be construed as a recommendation to buy or sell any particular security but is intended to increase your understanding of markets to help you make better investment decisions.)

The market expected GE to earn around $0.51 per share

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, and GE had indicated that they expected to earn between $0.50 and $0.53 per share. From this perspective, the result of $0.43 was a big disappointment to the market, especially for GE, which rarely disappointed the market with earnings announcements.

GE has long been accused of “earnings management”, that is arranging its business transactions in a way to produce continuously improving accounting results (see here for more on the topic). There are perfectly legal methods that a firm can use to ensure that earnings meet a particular target. For example

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, a firm whose income is a bit less than expected can delay some expenses until the start of the next quarter. If income is unexpectedly high in another quarter, the firm might realize some expenses earlier than necessary. Both these transactions will smooth out quarterly earnings.
As long as the amounts involved are relatively small, and the company is growing profitably, there is little cost associated with such transactions.

But once in a while a firm cannot meet the earnings target; perhaps all the news toward the end of the quarter was bad. In this case the company has to make a decision: should they make a heroic effort and still miss the market’s expectation by a small amount? Or should they admit as much negative news as possible, missing the expectation by a large amount, but setting the stage for positive developments in future quarters?

GE announced a number far below the market’s expectation and the market reacted strongly, because of GE’s history of meeting (or beating) the quarterly earnings expectations. But analysts more familiar with GE than I am will be able to decode the accounting statements and decide whether GE made all possible efforts and announced the best possible result (in which case the outlook for the future is very gloomy), made minimal efforts and announced the worst possible result (in which case the outlook for coming quarters should be fairly bright) or was somewhere in between.

The general lesson is that news does not have any particular significance outside the context of market expectations. Most people outside financial markets would have thought that earning $4.3 billion in three months represented a reasonable performance; only when you understand the specific history of GE’s alleged practices can you begin to understand why the market might react so strongly to such a number.

This entry was posted on Tuesday, June 24th, 2008 at 8:02 am and is filed under Markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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