What effect does a company's earnings have on the price of its stock?

Question

I have been trying to figure out the answer to this question this afternoon, and it seems like most people are saying that supply/demand determines the price of a stock.

It seems that earnings, which are reported every quarter apparently, have only an indirect impact on the price of a stock, in the sense that these quarterly reports influence the supply/demand dynamic which actually determines the price of the stock.

In this question, the accepted answer begins "Stock price is an indicator about the health of the company", but I don't really understand how it's an indicator of that.

It seems like buying stocks is basically like paying a celebrity for their autograph; the price of the autograph increases or decreases over time based on how much the fans are willing to pay for it.

I also checked out this other question, and learned that a dividend is based on the price of the stock (and not the earnings).

What is going on here? Is the entire stock market nothing more than rampant speculation the price of what amounts to corporate memorabilia?

Answer 1

No, the stock market is not there for speculation on corporate memorabilia. At its base, it is there for investing in a business, the point of the investment being, of course, to make money. A (successful) business earns money, and that makes it valuable to its owners since that money can be distributed to them. Shares of stock are pieces of business ownership, and so are valuable.

If you knew that the business would have profit of $10,000,000 every year, and would distribute that to the owners of each of its 10,000,000 shares each year, you would know to that each share would receive $1 each year. How much would such a share be worth to you? If you could instead put money in a bank and get 5% a year back, to get $1 a year back you would have to put $20 into the bank. So maybe that share of stock is worth about $20 to you. If somebody offers to sell you such a share for $18, you might buy it; for $23, maybe you pass up the offer.

But business is uncertain, and how much profit the business will make is uncertain and will vary through time. So how much is a share of a real business worth? This is a much harder call, and people use many different ways to come up with how much they should pay for a share. Some people probably just think something like "Apple is a good company making money, I'll buy a share at whatever price it is being offered at right now." Others look at every number available, build models of the company and the economy and the risks, all to estimate what a share might be worth, more or less. There is no indisputable value for a share of a successful business.

So, what effect does a company's earnings have on the price of its stock? You can only say that for some of the people who might buy or sell shares, higher earnings will, all other thing being equal, have them be willing to spend more to buy it or demand more when selling it. But how much more is not quantifiable but depends on each person's approach to the problem. Higher earnings would tend to raise the price of the stock. Yet there are other factors, such as people who had expected even higher earnings, whose actions would tend to lower the price, and people who are OK with the earnings now, but suspect trouble for the business is appearing on the horizon, whose actions would also tend to lower the price. This is why people say that a stock's price is determined by supply and demand.

Answer 2

A common (and important) measure of a stock's value is the price/earnings ratio, so an increase in earnings will normally cause the stock price to increase. However, the price of the stock is based on a guess of the value of the company some time (6 months?) in the future. So an increase in earnings today probably makes a higher earnings more likely in the future, and puts upward pressure on the price of the stock.

There are a lot of other factors in stock prices, such as publicity, dividends, revenue, trends, company stability, and company history. Earnings is a very important factor, but not the only factor determine the value (and so stock price) of a company.

Answer 3

Your autograph analogy seems relevant to me. But it is not just speculation. In the long run, investing in stocks is like investing in the economy. In the long run, the economy is expected to grow , hence stock prices are expected to go up.

Now in theory: the price of any financial instrument is equal to the net present value today of all the future cash flows from the instrument.

So if company's earnings improve, shareholders hope that the earnings will trickle down to them either in form of dividends or in form of capital gain. So they buy the stock, creating demand for it. I can try to explain more if this did not make any sense. :)

Answer 4

Your question paraphrased is: "Is stock valuable outside of its ability to be traded on the market?"

The answer is yes, via dividends. This is the only way I know of for a company's revenue stream to be directed towards shareholders. Everything else is just transfer of ownership of the assets that make that stream possible.

Even though dividends are a possible payout, don't let people fool you with poetic prose when they say "owning shares is owning a percentage of a company". If you own 1% of the shares in Apple, you can't just tell Apple to give you your 1% share of the revenue. It doesn't work that way. Dividend action is at the descretion of the board (majority shareholders) and executives.

Answer 5

In a rational market, price is a reflection of the net present value of future earnings. There's some dispute as to how rational markets are, but with the rational market model, while the supply/demand dynamic has a more direct effect on the price than does the future earnings, it is the future earnings that is driving supply and demand, and so suppl and demand are simply the mechanism by which future earnings set the price. Simply because one cause is less direct than another, does not necessarily mean that it is less valid to refer to it as the controlling cause. There being sugar in your kitchen is a less direct cause of there being ants, than the sequence of contraction and expansion of muscles in the ants' bodies, but which is a better explanation for why there are ants in your kitchen: "I left sugar out on the counter", or "Muscles in the ants' bodies contracted and expanded in such a way to propel them into my kitchen"?

There are two issues that limit the effect of earnings announcements on price. One is that the earnings are largely priced in before they're announced. If Apple releases a version of the iPhone that's really popular, and then a month later when their earnings report comes out, they report high earnings, people will have already expected high earnings, and have bid up the price. If the earnings report is the same as expected, the price won't be affected by it. If it's higher than expected, the price will go up, and if it's lower than expected, it will go down. So if you just look at what happens to stock prices after an earnings statement is released, it will seem like earnings have little to do with price. But that's because the effects are spread out in time as people get more and more of an idea of what the earnings will be, rather than all following immediately after an earnings report.

Anther issue is that earnings are important not only in themselves, but what the portend for the future. If the earnings announcement is $1 more than the market was expecting, then that in itself should cause the price to go up $1. But if the market believes that the increased earnings is evidence for earnings to continue to be strong in the future, the price will go up more than $1. What the market thinks of the future can easily be a larger factor in price than just the earnings in themselves.

Answer 6

Market price of a stock typically trades in a range of Price/Earnings Ratio (P/E ratio). Or in other words, price of a stock = Earnings * P/E ratio

Because of this direct proportionality of stock price with earnings, stock prices move in tandem with earnings.

Answer 7

It seems like buying stocks is basically like paying a celebrity for their autograph; the price of the autograph increases or decreases over time based on how much the fans are willing to pay for it.

Nailed it! Extreme example to illustrate: you could have a multi billion dollar company and if no one gave a shizer, the stock price would reflect exactly that. Unless dividends are in the picture. 😉🥂