What Drives Stock Prices?
Originally written June 15th, 2017, this story is intended for new investors who are looking to understand company valuations and how the stock market works.
An Introduction to Valuations
I had limited experience when I first dabbled in the markets at a young age. The investing adage “buy low, sell high” appealed to me as practical and logical advice. Seeing a stock take a dramatic nosedive, I would automatically consider it an appealing price.
Since the stock’s price was the only information I considered, I made assumptions on the valuation of a company by naively comparing yesterday’s price to today’s price. Needless to say, this speculative strategy did not work out so well.
Over time I have come to understand an objective framework which puts the “buy low, sell high” strategy in perspective for a long-term investor.
Consider the following exercise.
Imagine that you own and operate a small business. The business has no debt. Last year you did $250,000 in sales, from which you had $225,000 in gross income. Rent, salaries, and other expenses totaled $150,000. This leaves $75,000 as net profit. You have a healthy profit margin of 30%, calculated by taking the net profit and dividing it by the sales.
As the owner, you have a choice. You could take those $75,000 and give yourself a bonus, or you could keep the cash in the company to fund future growth.
You decided to reinvest in the business. You invested in marketing, sales, and purchase additional inventory.
Your projections for the current year are $350,000 in sales with $105,000 in net profit.
All of a sudden someone offers to buy your company for $500,000. What do you do?
Do you sell your company?
At first, many would be flattered with the gesture. You built this company from nothing and you are being offered half a million dollars. You created value, and as the sole owner, you could have a nice pay day.
Then you start to think about it more seriously. The business made $75,000 last year. Conservatively, if sales and profit were to stay flat, the business would generate $500,000 in under 6.67 years. Considering the current year’s plans of $105,000 in net profit, it would take less than 5 years. You have ambitious plans to continue growing and know you can keep growing. Down the road, you may even make $500,000 in net profit in one year alone!
Then you begin to consider the downside. What if there is a recession? Sales will likely suffer. What if competitors develop similar, or even better, products? It could put pressure on the business’s margins and affect the bottom line. Given the risks, maybe it is a fair price?
Let’s begin to analyze certain scenarios. The business made $75,000 in profit last year, and plans for $105,000 in profit this year. Surely $300,000 would be too low of an offer, while $3,000,000 would be an amazing deal.
But is $500,000 reasonable? Should you take it? If you counter, what would it be and why?
There are many factors to consider when valuing a company. The fact that the future is known makes it very difficult, if not impossible, to arrive at an exact valuation. The degree of certainty — or uncertainty — we have about the future plays a pivotal role.
Determining a reasonable range is often times the best we can do.
Even for this scenario, we would need to consider the quality of the earnings. What industry is the business in? How certain are we of this businesses’ future? Given the size of the company, we know there is some inherent risk.
I would deem something between $525,000 and $1,575,000 to be a reasonable offer. This equates to roughly 5 to 15 times this years earnings.
This is still a wide range. In the end, the closing price would come down to more art in negotiation and sales than precision in valuation.
Five years later
You continue to own and operate your business. Sales are now $1,200,000, but your net profit margin has come under pressure. The net profit for this year is $240,000.
Over this time, the valuation of this company must have increased. Strong growth has continued. However, the decline in profit margin may indicate the business is losing its competitive advantage. This may result in a lower multiple, perhaps 4–10 times earnings. The company would then be worth between $960,000 and $2.4m.
Connecting this to the market
When purchasing (or selling) stock, you are inherently agreeing to purchase (or sell) that company at the current market valuation. Determining the companies market value is clear and straightforward: simply multiply the price of a share by the total number of shares. It is commonly referred to as market capitalization and displayed almost next to every stock ticker. As opposed to selling an entire company, buying and selling shares can be a quick, low-cost transaction. Perhaps due to the ease of the transaction, many market participants act without considering the company’s intrinsic valuation.
It is clear that the large ranges of valuation can cloud the intrinsic valuation. As we saw earlier, the ranges of $0.5m-$1.6m and $1m-$2.4m are quite broad. This same phenomenon creates opportunities in the stock market.
This range would translate directly into a price range for the company’s stock. Given 100k shares, the above ranges would be equivalent to stock prices of $5-$16 and $10-$24. Different people come to different conclusions — some want to buy, and some want to sell. In the short-term, there is no telling what could occur to a stock’s price.
The key to investing is buying companies, or stock, below the low-end of your rational valuation range. This is commonly referred to as a margin of safety.
The key idea behind this story is to demonstrate how business fundamentals drive value over time. We can see that as earnings grow, the valuation tends to increase. Analyzing a company on its fundamental metrics is known as fundamental analysis. It is a framework that can be used to objectively guide buy and sell decisions.
While earnings are critical in the valuation of a company, there are many other fundamental metrics to consider when valuing a particular equity or stock. These include the company’s debt, cash, management team, competitive advantage, sector, and future opportunity, amongst others. The more information you have, the more you can narrow the valuation range. Applying this concept of fundamental analysis to the equities market is the key to “buying low, selling high”.
If these concepts are well-known to you, I hope this story may at least serve as a reminder that equity is ownership in a company, not paper that is merely traded.
