The way stock prices move may seem a mystery to many. One day the market moves up, the next it moves down – sometimes without clear reason.
A stock’s price is, at its core, the total worth of one share of stock of a company i.e. current and future cash flow and profits. This cash flow includes both the company’s operating profits as well as the dividend it chooses to provide to the shareholders.
As the predictions regarding the company’s future profitability change, the stock price will attempt to “price” those changes in.
The first major component of a company’s valuation is its earnings. Earnings essentially refer to the profitability from its business activities. Earnings are normally reported every quarter and provide essential information about how a company’s business is doing.
A company with strong earnings provides proof that its business activities are profitable. How a company’s earnings have increased or decreased over time also provides essential guidance on a company’s history and trajectory.
Current earnings are not the only important earnings factor – forecasted earnings that the company is expected to produce in the future are also vital. It is, in fact, a company’s future earnings that are the most essential in determining its current valuation.
An essential part of a company’s valuation comes from its dividend income stream. Many companies will eventually reach a stable level of development and not see much benefit in re-investing all their profits into their company for future growth. When this is the case, a company will often begin issuing a dividend to shareholders.
A dividend is a cash payment, usually paid quarterly but sometimes monthly or annually, that the company pays every current shareholder. For some companies (that do not see major growth on the horizon) their dividend income is the primary return for shareholders.
The dividend can change significantly depending on business circumstances. Dividend income is also often double-taxed: the business pays tax on their profits and then investors pay tax on the dividend income they receive.
Altogether, these cash flow streams from a company’s current and future business activities are what give value to owning a share of stock in the company.
All of these future cash flows are then discounted to their present value in order to determine the company’s valuation. This means that the future expected earnings are translated to their value in the present (which is based on how much money it would take right now, invested at the prevailing interest rate, to reach that future value when it is expected).
The formula for present value is:
Present Value (PV) = Future Value (FV) / (1 + Interest Rate (r) )^ (Time Periods (n) )
Or more concisely:
PV = FV / ( (1+r)^n )
By summing up the present value of all the future cash flows of a company, we can determine the present value of the company, which is its valuation.
The share price is then determined by dividing that valuation by the number of shares outstanding.
How is this Relevant to Me?
As an investor, it is helpful to understand the main drivers. Why? Because we live in a world of information overload. There are a thousand headlines a day that often fog the real stock price drivers, long-term. As a day trader, you care about those headlines, but as a long-term stock investor just remember: Earnings, Dividends, and Valuation.