What drives stock prices?

By March 6, 2020May 6th, 2021PFA Ponderings

I was on a finance committee meeting the other day with a non-profit board I sit on, when one of the other committee members looked at the investment portfolio and declared:  “Why are they invested 25% in international stocks?”  My retort was: “Is there a reason they shouldn’t be?”   His response was quite interesting: “Well, first, we’re a US organization!  And, second, international stocks have under-performed domestic stocks for the last 20 years!”

Beyond being dissatisfied with the logic, that exchange got me thinking about why we own any stock and what drives the prices and performance when we do?  Sounds like an easy enough proposition, but clearly there are a variety of opinions out there on what makes for a good or bad stock holding.

First, to be clear, the ONLY thing that makes stocks valuable are earnings.  When we buy a stock, we are buying future earnings.  Those earnings will eventually take the form of either dividends paid to us, or (hopefully) capital gains that we get to realize sometime down the road.

Since earnings are the only thing that makes a stock valuable, it logically follows that only two things should matter when considering purchasing a stock.

Thing One: How much are we paying for those earnings?

The price we pay for earnings is measured by something we look at a lot, called, logically, the ‘Price-To-Earnings ratio’, or simply ‘P/E’.  There are actually a lot of versions of the P/E ratio out there, but one we see referred to most often is the ‘Forward P/E’.  As its name implies, this measures today’s price against not past earnings, but earnings going forward.  Since we don’t know exactly what those are, this is a bit amorphous, but it’s not a bad place to start.

One important thing to remember, though, is that the earnings we’re looking at is for one year into the future.  Another way of thinking about this:  If we are buying a stock with a P/E ratio of 16, that means we’re paying $16 for $1 of earnings.  In other words, our investment will be paid back 1/16 of the way over the upcoming year.  So 15/16ths of the value of our investment is outside of that time period – further into the future!   And that leads us to….

Thing Two:  What is the direction of those earnings?

Predicting the next years’ worth of earnings is tough.  Predicting beyond the upcoming year is even tougher.  But predictions are all we’ve got.  We’re usually willing to pay more for a year’s worth of earnings if those earnings are expected to grow.  We’re also more likely to pay more for a year’s worth of earnings if all the other choices we have produce earnings that cost even more!  For example, assume we know that we can purchase a CD with a 1% rate of return.  If we do, we can assign a P/E to that CD.  That means the CD has a P/E of 100!  Way more expensive than our stock.  But if we can get 10% return from the CD, our P/E goes to 10.  Way cheaper!  For this reason, often higher P/E ratios are assumed to be justified in periods like now, where interest rates are low.

Right now, we’re dealing with huge levels of stock market volatility in part because markets are trying to account for a global economic slowdown in the wake of the Coronavirus pandemic.  ‘Price discovery’ becomes whipped around significantly.  The idea, in the case of, for example, airline stocks is this:  Earnings are dropping by 50%, and thus the prices should drop by 50%.

But the reason why prices typically rebound strongly after major market moves is this:  Markets are making assumptions way beyond the current year’s earnings, when in fact, these big disruptions often only impact earnings for a year or two.  Once longer-term earnings are revised to post-crisis numbers, the P/E ratios drive prices higher.

When looking for a reason to sit tight during big market disruptions like the one we’re facing now, here are three:

  • In the short term, markets are moved by way more than fundamental reality and fear is a much more significant emotion than hope. And…
  • In the long term, fundamentals do determine prices, and prices end up being based upon very long-term time horizons.
  • Long-term fundamentals are way more stable. And they’re based upon more defensible logic than you’re going to hear in the short term, even at finance committee meetings.