The Impact of an Earnings Upgrade or Downgrade on Bank Stock Prices - Research Paper

Introduction

Credit rating is the process of valuing the creditworthiness of a business organization. It assesses the ability of a business organization to pay back the debt either in terms of the bond or common stock. The process involves the assessment of the likelihood of a financial institution such as banks to default paying the amount borrowed (Al-Qenae & Wearing, 2002). The value of a firm or risk rely heavily on the market information, and therefore credit rating agencies such as Standard & Poor's spend a lot of money collecting reliable information that can be used to create concise recommendations concerning the state of a given stock. This paper, therefore, seeks to establish whether there is any positive or negative effect on upgrade or downgrade on bank stock prices. This is because upgrading or downgrading is a crucial factor affecting the price of a bond or common stock.

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The downgrade is an adverse change in credit rating. This condition occurs when the investors have the opinion that the value of the stock or bond has weakened significantly as compared to the initial recommendation. This happens as a result of a fundamental change in the operation of the banking industry. When there is a downgrade of the banking industry, the value of the stock or price of shares moves the rating from buying to holding because it is likely to make the bank get low share value which it cannot use to finance its financial operations (Zolotoy, 2012). Credit rating analysts provide a recommendation on bonds to ensure that their clients have general information of the future expectation of banking industry performance. The adjustment of these ideas when there is a change in the previous recommendation such as the price of shares of a bank. It, therefore, shows investors when the banking industry has had decrease its performance because of the current change in microeconomic factors.

The price of the stock of a bank can increase or decrease due to changes in its earning performance. This is because the profitability shows the financial performance of a bank and also highlights the current economic status for the bank earnings. This, therefore, makes long term potential investors not to be manipulated by quarterly fluctuating earnings although some investors respond immediately to short term earnings. The price of the stock is rated low when the bank has lower incomes than the expectations set by credit rating analysts (Zolotoy, 2012). This makes investors show their disappointment by selling their shares at a lower price. This happens when there is downgrading. On the contrary, when the earnings of the company surpass the price, the analysts expect from the bank earnings is upgrading. This increases the price of shares of a banking institution as it will increase the shared demand.

Since credit rating is the opinion of the public about the credit risk of a bank or any firm as produced by the rating agencies, the information can change the stock price of a bank either positively or natively. The credit rating is a reflection of the current financial performance of a business organization; it is, therefore, an important factor for both investors or issuers of a bond. When the bank has an upgrade or high credit rating, it means that the bank has an excellent financial performance saying that it can meet its financial obligations (Welc, 2014). This condition help banks to issue their stock at high prices because it is perceived to generate high returns in the future. Investors will view the bank to be very profitable, and therefore they will have confidence when buying the bank shares thus are sure of receiving high returns from their investment. High credit rating also builds trust in the market for both the bank customers and shareholders as it reflects what the bank can generate in the future.

When the company has a low credit rating it means that the company is performing poorly and this kind of information hurts the share price; the investors will get a negative opinion about the bank which results in a loss in confidence in the bank. The potential investors will therefore not buy the shares of the bank. This information will, therefore, reduce the demand of bank shares thus lowering the price of stocks. Such information in the market will be reflected in the share price of the bank (Welc, 2014). This is because the result of the credit rating is usually published. The publication of the result yields a sharp market reaction after the announcements. It, therefore, helps investors to access relevant information that they require when making investment decisions.

Conclusion

The potential investors that can buy shares from the bank in which they understand its financial performance, credit rating, therefore, help them know microeconomic factors used in choosing stock of a bank that offers maximum returns within a given level of risk. Banks that are riskier are incapable of meeting their financial obligations have a lower demand for its shares due to weak growth potential as perceived by the potential investors. This is the condition called downgrade which makes the public to view the company negatively thus making the price of the stock to reduce significantly.

References

Al-Qenae, R., Li, C., & Wearing, B. (2002). The Information Content of Earnings on Stock Prices: The Kuwait Stock Exchange. Multinational Finance Journal, 6(3/4), 197-221. doi:10.17578/6-3/4-3

Well, J. (2014). Impact of Earnings Smoothness on Stock Prices, Stock Returns, and Future Earnings Changes - the Polish Experience. European Financial and Accounting Journal, 2014(3). doi: 10.18267/j.efaj.125

Zolotoy, L. (2012). Earnings Surprise Implicit in Stock Prices: Which are Earnings Forecasting Models are Investors Using and What Determines Their Choice? Journal of Business Finance & Accounting, 39(9-10), 1161-1179. doi:10.1111/j.1468-5957.2012. 02303.