How Expectations Drive Penny Stock Prices - dummies

How Expectations Drive Penny Stock Prices

By Peter Leeds

Companies grow as they increase their sales and profits; when a penny stock company grows, its stock price will often increase. But the relationship between a company’s growth and rising stock prices isn’t a direct one. Instead, the rise in value of the stock is based on investors’ expectations of higher future results based on those latest numbers.

In most cases, investors anticipate what they expect a company to do, and the shares reflect that expectation more than actual results that were attained previously. In other words, investors are forward looking, and a stock’s value is based on what it may do, rather than what is has already done.

When information becomes publicly available and investors adjust their expectations based on that information, the shares of the stock in question will change.

Expectations of penny stocks are more important than results

Investors who profit the most from penny stocks generally have a solid understanding of a company’s expectations and actual results and know how the two relate to each other.

The shares of most larger companies are based primarily on results, with only a small amount of their value coming from expectations. Penny stock markets, on the other hand, react more to expectations than results. Investors familiar with larger markets but new to penny stocks are often surprised when a penny stock that has just reported a doubling of its sales doesn’t see an increase in its share price.

If a company doubles its sales, this result will only have a positive impact on the underlying shares if the market was expecting less than that. If investors had been anticipating a quadrupling of sales, the announcement of doubled sales may result in the share price collapsing.

Investing well has a tremendous amount to do with spotting the companies that are exceeding expectations rather than finding those that are simply growing. This strategy is especially important with penny stocks because their prices have more of a basis in speculation and they are prone to rapid and dramatic price moves when expectations and real results divert.

Besides finding those penny stocks that may beat expectations, it is also important to avoid those stocks whose expectations may fall short. Penny stocks that don’t meet or exceed what the stock market expected may see their shares heading lower, whether or not their companies are enjoying operational growth.

Expectations are more important in penny stocks than in larger companies for the following reasons:

  • The fog of war. Penny stocks have fewer analysts following them, and the companies issue guidance much less frequently. This lack of information leaves a lot more mystery surrounding the potential financial results, and so when the actual numbers come to light, there can sometimes be a major reality check for investors.

  • One-trick ponies. Penny stocks usually have very few business lines or products and very often they have only one. When expectations for sales, or customer adoption and retention, don’t match up with actual results, that disconnect will have significant implications on the viability and acceptance of the company’s product or service. When investors realize that everyone is buying, or that no one is, the share prices will immediately react.

  • Speculation has more uncertainty. Penny stocks are traded more on speculation than results — on what a company could do compared to what it has done. You could say that investors rely more on hope than quantifiable results. Speculation by its nature gives penny stocks wider price spreads, and there is often a lot more room for correction when those expectations are compared with a company’s real results.

  • These companies are babies. Penny stocks usually inhabit an early phase of their corporate life cycle. Many of these penny stocks don’t have revenues, earnings, or even a history of results for comparisons or to gauge growth against. The price of these shares may be based entirely on expectation, and whether the shares do well may be based primarily on changes in forward-looking speculation.

Beat estimates

When a stock beats estimates by releasing financial results that are better than the company and most analysts predicted, the shares tend to go higher. The degree of the upside move depends on the amount by which the company beat the estimates.

If only one or two analysts made predictions on the operational results of the company, beating their estimates may not have a significant effect on the share prices. If several analysts made the same prediction, or the estimates of the company itself were beaten, then there may be a significant upside response among shareholders.

Missing penny stock guidance numbers

When a company’s reported financial results fall short of investor expectations, this is called “a miss,” or “missing estimates.” When a penny stock doesn’t deliver what investors were anticipating, the shares usually decrease in price as a response. For example, when a company is expected to earn $2 per share, but their final results fall short with earnings of only $1.75, that company is said to have missed estimates.

Companies that miss estimates have an instant negative reaction in their share price. Investors anticipated that the results would be stronger, and the stock reflected that expectation; as soon as the financial numbers fall short, the share price drops lower to account for the weaker-than-expected performance.

The weak numbers may indicate growing problems with the company, a trend of decreasing acceptance of the products or services, problems with the company’s distribution network, or some other significant issue. Estimates going forward will need to be lowered, unless the company has a legitimate reason why there was weakness in the reported quarter that they expect to rectify, such as a worker’s strike or any other one-time event.

Misses in guidance can be one of your earliest warning signs that not everything is going well with a company and may serve as a valuable indicator that you should sell your holdings before things get worse.