What Drives Stock Prices?

An Introduction to Valuations

  • Intended for new, long-term investors who are looking to understand valuations and the stock market.
  • Demonstrates the importance of earnings over time through a relatable exercise.
  • Introduces fundamental analysis, anchored by earnings.

When I first dabbled in the markets at a young age, I had no experience. The "buy low, sell high" investing adage appealed to me as practical and logical. I would see a stock that had a heavy drop and automatically label it as undervalued. Since the stocks price was all I analyzed, I assumed that the relative pricing was what determined valuation. Needless to say, this speculative strategy did not work out so well. Over time I have come to better 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, leaving $75,000 as net profit. You have a healthy profit margin of 30% (net profit divided by sales). As the owner, you now 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 decide to reinvest to improve the site, invest in marketing, and purchase more inventory.

The 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?

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 very nice pay day coming.

Then you start to think about it more seriously. The business made $75,000 last year. Conservatively, if sales and profits were to stay flat, the business would generate the $500,000 in under 6.67 years. With the plans for this year to do $105,000 in net profits, 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 the $500,000 in profits in one year alone!

Then you begin to consider the downside. What if there is a recession? Sales will likely suffer. What if competitors start selling similar or 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 the offer with knowns. The business made $75,000 in profits last year, and plans for $105,000 in profits 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?

In valuing the company, there are many factors to be considered including from the past, present and future. This makes it very difficult, if not impossible, to arrive at an exact valuation. Coming up with a reasonable range is the best we can do in. In this scenario, I would deem anything between $1.2m and $2m to be a reasonable offer, which is roughly 12 to 20 times this years earnings. 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, tighter profit margin may result in a lower multiple of 10-20 times earnings. The company may now be worth between $2.4m and 4.6m.

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 $1.2m-$2m and $2.4m-$4.6m are quite broad. This same phenomenon is what creates opportunities in the stock market. The companies valuation range would translate directly into a price range for the stock. Given 100k shares, the above ranges would be equivalent to stock prices of $12-$20 and $24-$46. In the short-term, there is no telling what could occur to a stock's price. You would be surprised at the price-to-earnings disparities that can occur. The key to value investing, which I will explore more fully in a later post, 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 idea here is to demonstrate how business fundamentals drive value over time. We can see that as earnings grow, the valuation increases. 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, 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".

To the investors for which this is known, I hope it serves as a reminder to always treat equities as ownership in a company and not paper that is being traded.

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