How Stocks are Priced, Part 2 – Fundamental Factors

This is a continuation of the series of posts on stock pricing.  Today I will  talk about the basic components of stock pricing, which I call Fundamental Factors.  These fundamental factors are 1) the current earnings, 2) the predicted earnings growth rate, 3) the current dividend (yield), and 4) the predicted dividend growth rate.   The first post of the series is here:

Let us imagine that one could predict with absolute certainty how much money a company would earn per share.  For simplification, also imagine that all of the earnings was paid out to the shareholders as dividends.  If stock XYZ earned $1.00 per share, each owner of XYZ would receive $1.00 for each share they held.  A holder of 100 shares would get $100.

Because one knew with certainty that one would receive $1.00 per share, one would compare the current yield from the stock with interest rates at banks.  If a bank were paying 5% per year in a savings account, which could also be considered a predictable return (for all intents and purposes), one would expect $20 in the bank to return $1.00 per year in interest.  One would therefore bid up the price for the share of stock until the price was $20 per share, such that one would also get a return of 5% per year.  If the stock were priced lower, investors would withdraw money from the savings account to buy shares of the stock since the yield was higher.  Likewise, if the stock price rose above $20 and investors were receiving less than 5% (because they would still be receiving $1.00 per share), investors would sell shares and put money into the bank since the yield was higher there.

Earnings are similar to dividends in that while the company may not pay our earnings in dividends (and some younger companies do not pay dividends at all), one can expect that a company will eventually pay much of its earnings out to shareholders as dividends.  In the very least, if the company were ever acquired, the rate of return the suitor would achieve would be equal to the earning s per share, so the purchase price would be dependant on the earnings.

Because of the reasons above, the pricing of a stock at the current moment is based somewhat on the current earnings and dividends.  In investing in stocks, however, one looks into the future.  If earnings and dividends are expected to rise, one can expect to be getting an even greater return for their investment in the near future.  If a stock has had increasing earnings in the past and that growth is expected to continue into the future, investors will bid the price of the stock up, taking into account future earnings in their calculation of potential return.  Because the long-term trend follows earnings and dividend growth rate fairly well, if one can find stocks that have consistently growing earnings, one can expect the price of that stock to increase by the same rate over time.

There is a caveat, however, and that is stocks do not typically have fully predictable earnings.  It is easier to predict earnings of some companies more easily than those of others, but it is virtually impossible to predict earnings for a company exactly since markets may change, plans may be executed poorly, and other factors can affect future earnings.  Because of this, there is a risk factor included into the price of a stock.Investors will judge the risk of not achieving the return expected for a stock based on factors such as how predictable their earnings are, how volatile their market is, and how competent the management has been.   If a sure investment like a bank account is paying 5%, investors may bid down the price of a stock until the expected return is 10% or more so that the potential return is worth the added risk.

This is the reason that investing in stocks will return more than bank accounts.  Because the risk is greater, stocks are priced such that the return is greater when things do work out as planned.  By buying a group of stocks to reduce the risk that any one position will fail one can achieve returns over long periods of time that are vastly superior to bank accounts and other fixed-income investments.

In the next post I’ll go into comparative factors:

To ask a question, email or leave the question in a comment for this blog.

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. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  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

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