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I have heard that people say the greater earning means greater intrinsic value of the company. Then, the stock price is largely based on the intrinsic value. So increasing intrinsic value due to increasing earning will lead to increasing stock price.

What is the relationship between the earnings of a company and its stock price?

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In general over the longer term this is true, as a company whom continuously increases earnings year after year will generally continue to increase its share price year after year.

However, many times when a company announces increased earning and profits, the share price can actually go down in the short term. This can be due to the market, for example, expecting a 20% increase but the company only announcing a 10% increase. So the price can initially go down. The market could already have priced in a higher increase in the lead up to the announcement, and when the announcement is made it actually disapoints the market, so the share price can go down instead of up.

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  • ok, so what's the mechanism behind this long term process ? I mean why higher earning increases the demand for this stock; thus, increasing its price. I'm just very confused on this point. Feb 16, 2015 at 21:24
  • @ChenxiongYi, If you were to buy a business off someone else would you pay more for a business not making any profits or for a business making alot of profits and increasing those profits year after year?
    – user9822
    Feb 16, 2015 at 22:00
  • yes, intuitively, it should be the one that has lots of profit. But how can buyer benefit from the profit ? do they get more dividend or make money from appreciation ? Feb 16, 2015 at 22:03
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    Yes, and yes, potentially. Companies manage their stock price to be high enough to discourage takeover (repurchasing when that makes sense), so price longterm tends to track that risk, which tracks their value. Dividends theoretically should track profit, since they're you portion of net profit after reinvestment... but the balance between dividends and reinvesting can be adjusted depending on the company's needs and whether the stockholders are demanding more dividends or higher stock price.
    – keshlam
    Feb 16, 2015 at 23:45
  • @ChenxiongYi, well that is what drives the demand for stocks with increasing profits, more people would prefer to buy stocks in company's with increasing profits rather than ones with decreasing profits. These increasing profits can be used to grow the company further or to return to shareholders as higher dividends, or a combination of the two. If you buy shares in a company which increases profits year after year for 10 years and you sell after 10 years, you will most probaly have sold for higher than you bought at and probably would have received increasing dividens over the 10 years.
    – user9822
    Feb 17, 2015 at 5:42
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I have heard that people say the greater earning means greater intrinsic value of the company. Then, the stock price is largely based on the intrinsic value. So increasing intrinsic value due to increasing earning will lead to increasing stock price. Does this make sense ?

Yes though it may be worth dissecting portions here. As a company generates earnings, it has various choices for what it can do with that money. It can distribute some to shareholders in the form of dividends or re-invest to generate more earnings. What you're discussing in the first part is those earnings that could be used to increase the perceived value of the company. However, there can be more than a few interpretations of how to compute a company's intrinsic value and this is how one can have opinions ranging from companies being overvalued to undervalued overall.

Of Mines, Forests, and Impatience would be an article giving examples that make things a bit more complex. Consider how would you evaluate a mine, a forest or a farm where each gives a different structure to the cash flow? This could be useful in running the numbers here.

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You would think that share prices is just a reflection of how well the company is doing but that is not always the case. Sometimes it reflects the investor confidence in the company more than the mere performance.

So for instance if some oil company causes some natural disaster by letting one of there oil tankers crash into a coral reef then investor confidence my take a big hit and share prices my fall even if the bottom line of the company was not all that effected.

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There is no fixed relationship valid for every single company at every single time.

Firstly, nominal interest rates and inflation change over time. This means real interest rates of government bonds change. You might want to buy a widely diversified portfolio of stocks at 25 times their earnings if the real interest rate is negative like it is now, but would you pay 25 times earnings for the same portfolio if real interest rate is 3%?

Secondly, earnings is affected by financing of the company because you subtract interest payments from earnings. You can think of one very strongly financed company with practically no debt and thus practically no possibility of it going every bankrupt, and another company on the verge of bankruptcy. Using P/E valuation (price per earnings), you will find very different valuations for these two companies. Using EV/EBI (enterprise value per earnings before interest) would be somewhat better but usually EBI isn't published so you need to use EV/EBIT (enterprise value per earnings before interest and taxes) and then you can compare only companies having the same tax rate. Actually for differently financed companies EV/EBIT is far better than P/E, but for a company on the verge of bankruptcy EV/EBIT also falls to indicate a low valuation, but you shouldn't invest to such a company because of its low valuation. The reason for debted companies having lower P/E is that debt is cheaper than equity, because interest rates are less than profits from stock market investing. Therefore, a company can leverage its profits by using more of the cheaper financing and leaving less need of having shareholders to provide capital.

Thirdly, the growth rate of companies differs massively. For example, Tesla has P/E ratio of 175, because investors assume electric car market grows exponentially and Tesla continues to be its leader, and that Tesla might have possibility to use its technology in other clean energy projects too than electric cars. Those assumptions might be overly optimistic, however, and you shouldn't therefore invest to Tesla at its present valuation. However, the oil and gas company Shell has P/E of 10.37, because oil use is threatened by the widespread adoption of electric cars, so the oil part of its revenue has only short future. Gas may be used for a longer period of time, but eventually clean hydrogen produced from electrolysis threatens it too. So high growth may mean P/E is high and low growth may mean P/E is low.

Also, different sectors usually have different P/E values. P/E values of banks may be low because banking is an inherently risky business, and P/E values of bulk industry like steelmaking may be low too because the product is a bulk product and small fluctuations in demand can cause large fluctuations in profitability. However, fast-moving consumer goods companies usually sell well at all parts of economic cycles, so this may justify a higher P/E despite not having massive growth rates. So riskiness of the sector can cause variations in the natural P/E. Usually higher risk needs higher returns, so higher risk investments need a lower P/E.

If a company has inherent shields against competition, a higher P/E may be justified. For example, the industrial gas sector is a sector where every company is essentially a local monopoly in a small area due to being dependent on massive capital investments and due to being ecomonically impossible to ship industrial gases across long distances. If one company sells industrial gases in a limited industrial area, it doesn't make sense for a second provider to make capital-heavy investments in the small area unless the first company is charging excessive fees from its industrial gas production. The first company knows this and decides to charge very very slightly less than excessively. Thus the second company will never establish its presence in the area. Air Liquide is an example of industrial gas company, and it has a P/E of 27.68. That is a bargain at current real interest rates despite sounding high.

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