The pricing of stocks remains a mystery for many. Why do stocks increase in price? Why do some stocks beat the market while others don’t? And what do earnings have to do with stock price? Finally, what is the significance of Price Earnings Ratio (P/E Ratio) and how can the small investor use it to select stocks and predict future returns? Understanding stock pricing is a key for building a solid investment strategy.
Today I will continue to lay the ground work for the discussion of how a small investor can beat the market returns with a discussion of stock pricing. Today’s post will lead into a discussion of predicting future stock prices based on earnings growth, which will then lead to a discussion of how to pick stocks that are likely to increase in price in the future faster than the market. The original post of this thread provides the theme for this series, A Strategy for Market Beating Returns, for any who missed it:
To understand stock pricing, one must realize that there is both a current market price and an intrinsic value for any given stock. The two are related, in that the market price will tend to follow the intrinsic value, but the two prices can vary greatly for short periods of time due to market conditions. The market price is whatever price at which the stock last traded. It is the quote reported on various websites and in the newspapers (those that publish quotes anymore). It includes the intrinsic value of the stock, the effects of current market conditions, news stories, the effects of recent movement in stock price, the number of people wanting to buy or sell the stock and their level of motivation at any given moment, and other factors. The market price of a stock is very difficult to predict with any certainty because there are a wide variety of unpredictable factors that influence it.
The intrinsic value is the basic worth of the stock – the value that the stock would sell for if everybody ignored the news and traded based on emotionless reasoning. What the company is worth do to the assets they have, the revenue they are producing, and the prospects for future growth. To think of it another way, if investing involved throwing a stick into a turbulent stream and the price of the investment depended on where in the stream the stick was at any moment, the intrinsic value would be the position due to the average speed of the stream while the market price would also include the random fluctuations due to eddies, rocks, and other features. It would be very difficult to predict where the stick would go at any given moment, but it would be fairly easy to predict the approximate location of the stick in the stream after an hour or two.
Because the market price tends to follow the intrinsic value of a stock over long periods of time, and because the intrinsic value is much easier to predict, investing should be done for long periods of time based on expected future intrinsic value. Doing so puts the odds in the investor’s favor.
Like any investment, the intrinsic value depends on the potential return, the risk of getting that return, and the current return of other possible investments. The potential return is how much income the stock is expected to produce for the investor over the next several years, which depends on current dividends and predicted future dividends. (Note that earnings and dividends are nearly synonymous. The expectation is that as the company matures it will start to pay out most of its earnings in the form of dividends, so even if it does not pay a dividend now it will do so in the future and the rate will be based on the earnings it has at that time.) If the stock is paying a large dividend compared with the returns of other investments — or is expected to in the future — the price will be bid up since people can get a better return in the stock then they can elsewhere. Likewise, if the dividend paid by the stock drops or if other investments raise their rate of return, the stock will drop in price until the dividend yield becomes large enough to justify an investment in the stock.
The second factor is the certainty of those returns, because the earnings are not guaranteed by any means. If one knew what the earnings and dividends were going to be over the next ten to twenty years with certainty, one could determine the rate of return exactly by dividing the dividends to be paid by the current price. In that case, if one could invest in a bond and get a guaranteed 5% return, one would not invest in the stock unless the rate of return was also at least 5%, which would mean the stock price would need to drop until the return was at least 5%. (Remember the rate of return is the amount received divided by the amount invested, so if the amount received stays the same while the amount invested drops, the rate of return increases).
There is no way to know for sure what the future dividends will be, however, so investors will pay less, relative to yield, for a stock so that their potential rate of return is greater than other, less risky investments. If future dividends were considered very uncertain a stock might decline in price until the projected rate of return was 10% if bonds were providing predictable returns of 5%. In that way the investor would be more likely to get at least the 5% return if a few different stocks were purchased. For stocks that have more predictable yields, like an old company in a stable business that pay a $0.30 dividend per share like clockwork, the price might be higher such that only an 8% return was created.
Finally, as hinted to above, the price will depend on the rate of returns of other investments. If less risky investments — those with a more certain return — are paying 5%, a more risky stock might be priced to provide a 10% rate of return. If the yield of the less risky investments declined to 3%, the price of the stock would increase until the rate of return was 8% since investors would be willing to take more risk for the greater return. Of course, the stock price would decline if the yield of other investments rose.
We have now explained how earnings, which translate into dividends, and perceived risk affect the price of the stock. In the next post we will look at price earnings ratio, earnings growth rate, and how the combination can be used to predict future prices.
See the rest of this series: https://smallivy.wordpress.com/category/making-market-beating-returns/
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.