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Comment by Shinkei | Hacker News Reader

I never understand this phenomenon of how shares instantly drop in value based on a single quarter of earnings that don't meet 'estimates.' Suffice it to say, I do understand a bit about markets, but maybe somebody can educate me further.

There is no way that individual investors are moving the stock enough in the minutes to hours post-earnings report to actually affect the price, so I'm assuming this is 'market makers' that are selling off shares and pushing the price down. But my question is... are they selling shares because they predict other people will sell shares and so they are simply 'beating' the rest of the market to avoid the predicted loss? Or are they selling the shares because they actually believe they are worth less due to the report?

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Massively over-simplifying, the price of shares is what the last trade was at. So it does not require a high volume to change the price - just buyers and sellers agreeing on a different value.

And what is that value? The value of a share is the market's best estimate of the present value of the future revenue earned from owning that share. Those earnings can happen from dividends, stock buybacks, a takeover bid, etc. But fundamentally they are an estimate of future profits.

So why does it move so fast? If you tell me that a major metric, the revenue/ad, dropped 5% and all else held the same, unless you have a good explanation for the anomaly, my simplest estimates of your future revenue just dropped 5%. If I am afraid that the drop could be a long-term trend, my estimates might drop further. If I believe that the metric has reasons to recover, my estimates might drop less.

But the natural tendency is to base estimates of future revenue on current rates of revenue. So a one quarter drop in current revenue results in a corresponding drop in share price. (And vice versa.)

BTW Google don't pay dividends and promises to don't pay "in the foreseeable future".

http://investor.google.com/corporate/faq.html#toc-dividend

This is true. However 5 years ago the same could be said for a number of other tech companies including CISCO, Oracle, and Apple. Yet all have since paid dividends or done stock buybacks.

The market operates under the assumption that all other companies that stay profitable long enough will eventually do the same. And as long as management is seen as competent, is indifferent about whether "eventually" comes tomorrow or 20 years from now.

For an extreme example, the markets have long rewarded Berkshire Hathaway for its growth in profits, even though no money was returned in any way to investors for 40 years. (There has since been a small buyback.)

I think that when a founder is no longer at the helm, companies have to do more mainstream things when it comes to appealing to wall street.

This is exactly what happened with Apple.

Wall St doesn't mind if it takes 5 years or 50. As long as they know how to crunch the figures for current value, and can speculate about future revenue.

Don't forget that employee stock compensation also involves repurchasing shares off the market - which means some of the company's earnings do make it back to investors.

Actually I will try to forget that, because it is wrong.

Many companies have the ability to cover employee stock compensation by issuing more shares. This dilutes existing ownership rather than returning value to investors.

If you want your eyes to glaze over, http://www.sec.gov/rules/final/33-8048.htm describes the SEC rules for how public companies need to tell their investors (who also generally own the company) what the risks are that their share of the company will diminish due to new stock being created for things like employee incentive plans.

Of course if you're an investor, your eyes shouldn't glaze over. Because we're talking large sums of money. For instance for Google in Q1 of 2013, we're talking something like $697 million of value transferred from existing investors to employees. (Search for "SBC" in http://investor.google.com/earnings/2013/Q1_google_earnings.... to see where I pulled that figure from. I won't guarantee that I read the filing correctly though.)

Dividends are only one way to value to companies. If Apple fired everyone tomorrow and stopped selling products, their stock would still have value because of the cash (and real estate, etc) they have on the books.

Buffet basically assumes that he is a better investor than his shareholders and by not paying taxes twice (corporate and individual) on dividends he will do better investing the profits and growing book value than his shareholders. Pretty good assumption so far.

Actually, no. Dividends don't give companies value. (In fact every time you pay one, your stock price drops by the amount of the dividend.) They return value to shareholders.

Yes, you're right about Buffet. And because the market is indifferent about when money gets redistributed, they are happy at this point to pay around $100K/share despite those shares having value tied up in a company that has shown very little willingness to distribute any earnings to investors.

> Suffice it to say, I do understand a bit about markets

> so I'm assuming this is 'market makers' that are selling off shares and pushing the price down.

No. That is not what a "market maker" does.

A market maker does not take directional positions on a stock -- either long or short. Their goal is to make money on the bid-ask spread, and they try to maintain a net-zero position, so far as is practical.

The purpose of a market maker is to provide liquidity, by ensuring a sufficient tight bid-ask spread. By definition, this means that they are buying when others are selling, and selling when others are buying. Thus, if Google shares are going down due to selling pressure, then market makers would be buying.

>are they selling shares because they predict other people will sell shares and so they are simply 'beating' the rest of the market to avoid the predicted loss? Or are they selling the shares because they actually believe they are worth less due to the report?

Those are two sides of the same coin.

Stock prices are probabilistic in nature, because we're all operating with incomplete information. Consider an envelope that has randomly been prepared with either a $1, $5, or $10 bill inside (let's say someone rolled a die to determine the bill, put the bill inside, then gave it to someone else). Assuming equal probabilities of each bill, the envelope would have a market value around $5.30. If you wanted to buy it, that's about what you'd have to bid to win. Now imagine the person who prepared the envelope revealed that the $10 was not inside. Everyone bidding more than ~$2 would retract their bids, so now you only have to bid ~$2 to win it. They don't believe the value of the envelope actually decreased (the bill stayed the same), but now they have information that changes the market price.

That envelope would then be worth ~$3, not ~$2.

That's right, my mistake.

The shares instantly drop in price because the price of a stock is based on the perceived value of the company. A release of new information can instantly change the value investors perceive a company to have. Shares of public companies like Google are being bought and sold every second, so a change in perceived value is reflected instantly in actual sale prices. However, buying and selling isn't necessary to change the perceived value of a stock. The perceived value of a share of a private company could change even if nobody is buying or selling shares at the moment. So, a change in stock value isn't necessarily related to a change in the number of shares people want to buy or sell.

Once the news hit, there was a demand for a discount on the stock, for obvious reasons, with nobody willing to sell at more than a 5% discount, so there you go, an instant 5% move to where a buyer finally found a seller.

If you're asking why sellers were willing to sell at that price, well, there were plenty of people willing to sell at a 4% discount instead of a 5% discount, but no buyers. All market participants have different opinions on the effect the news had on future cash flows, but the 5% magic number was the place where there was a consensus between bulls and bears on a fair price. The price of the stock only shows you where a consensus between a buyer and seller was reached, and doesn't tell you much about the structure of the order book or option chain for a stock, which indicates a lot more about what all market participants think about a stock.

Warren Buffett says stock prices are like a crazy guy knocking on your door everyday and throwing out a random number which "supposedly" represents your stock's price for the day.

That's how much stock prices represent reality and the worth of a company.

At a high level, we can consider the current buy demand to be weak based on the new information.

If bad news just came out, would you immediately want to buy? No, you'd probably wait. That overall pressure results in a downward movement in price.

Further, there is pressure for current holders to sell because they know there is going to be downward pressure. They can sell without much concern. Even if they really want to maintain their position, they can sell short term and buy back in later at a lower price.

The more significant the news, the more obvious the pressure will be and at a higher expected intensity - so more people will behave as described above.

They can make money on volatility, up or down. My uneducated guess is that they use the quarter figures as an indicator to make it easier to push the price down.

I don't think there is any long term reason for the stock to go down based on the latest quarter. Google are putting more ads in front of people, which means those bidding lower are getting more clicks, that will be why the average cost per click is down.

Google is making big changes in shopping and ecommerce ads which they stand to make a lot from long term.

Why not? Is there data about how much of GOOG or other stocks is owned by "individual investors" vs market makers?

There is, to some extent.

http://www.nasdaq.com/symbol/goog/ownership-summary

FMR LLC owns 18 million shares, Vanguard owns 12 million, Barclays owns 7 million, etc.

Worth noting that those names highly likely point at index funds. In other words, a lot of those shares are economically in the hands of small investors.

(I'm sure some of them are in my 401K.)

Fidelity is mostly actively-managed, as is T. Rowe Price. They may still be owned by small investors, but they are not index funds. Rather, they're "mutual" funds.

State Street and BGI are 100% indexed, and Vanguard is 90% indexed.

Thanks for the clarification –- I misspoke. The distinction I was trying to draw is that this is most likely not prop trading.

Those are "institutional investors," not "market makers." Market makers try their best to hold 0 shares.

Note that some of Fidelity's shares, about 90% of Vanguard's shares, and 100% of BlackRock's [1] shares are held on behalf of index funds or index-linked ETFs. As passive holders, they do not trade on market news.

[1]: Barclays Global Investors is actually owned by BlackRock, not by Barclays.

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