What is Profit Warning?
A profit warning is a public communication from a company that its earnings will fall below expectations.
How Does Profit Warning Work?
Profit warnings are part of the large, fluid world of earnings guidance, whereby the management of publicly traded companies issue estimates about what they expect earnings to be for the coming quarter. The guidance is based on management's experience, calculations, and outlook. Management earnings estimates significantly influence the analysts covering the stock, because the analysts incorporate these estimates into their own research and earnings forecasts for their clients.
Before August 2000, it was legal for public companies to provide earnings estimates to chosen analysts rather than publicly disclose these estimates. The SEC's adoption of Regulation FD prohibited this selective disclosure of information, and public companies must now publicly disseminate earnings estimates to analysts all at the same time.
When management becomes aware that the company probably will not meet the expectations it previously communicated, the company typically issues a profit warning via press release or conference call with analysts several weeks before announcing quarterly earnings.
Why Does Profit Warning Matter?
Earnings estimates considerably influence stock prices because they help investors evaluate a stock's potential. If investors expect a company to report, say $0.10 in earnings per share next quarter, but the company actually reports $0.08, many investors might sell the stock and the company's stock price will therefore probably fall after the announcement. Conversely, if the company reports $0.12, the stock price will probably rise. The degree of "miss" or "surprise" influences how much the stock price will change. This is why profit warnings are usually a company's attempt to soften the blow of a pending below-expectation earnings announcement.
Some companies do not give guidance, and thus do not issue profit warnings. The choice to not provide guidance is usually made to reduce legal liability in the event that management's estimates are wrong. Some analysts claim that companies that do not offer any guidance often receive a "break" on stock price changes when these companies miss earnings, because the market is aware that the company's management has given the analysts (and their resulting estimates) no input.