Why is stock price related to company earnings? No really.
February 26, 2012 5:47 PM   Subscribe

So I completely understand that prices of stocks, like anything in a market, arise from supply and demand. But at the end of the day, why does demand for a stock increase when a company's earnings increase? How does holding the stock of a company whose earnings have increased since purchase benefit a stockholder? It can't purely be that I care about earnings because I know everyone else cares about earnings because they know everyone else cares about earnings... can it? What is the ultimate source of this caring about earnings? If dividends were more common, I could understand all this as a jockeying for a good deal on a dividend. But as it is, it sounds no different than betting on a never-ending horse race with earnings arbitrarily picked as the indicator of which horse is in the lead.
posted by the jam to Work & Money (21 answers total) 9 users marked this as a favorite
A share of a company's stock, when it comes down to it, is a share of the company. When you own stock in a company, you own part of the company. Think about it in the extreme: a company has two shares of stock, each owned by a separate person. Ownership of the company is split evenly between those two people. When the company makes a profit, they can either reinvest the profit in the company, or they can pocket the profit. (Pocketing the profit is analogous to a dividend.) It also means the two shareholders split control of the company evenly. Now scale that up to millions of shares.

The market cap of a company is the ostensible value of the company. It's the share price divided by the number of shares issued.
posted by supercres at 5:59 PM on February 26, 2012

you might buy with the expectation that the price will either continue to go up, or the company will start issuing dividends.

…or that the company will be bought by another company.
posted by esprit de l'escalier at 6:00 PM on February 26, 2012 [2 favorites]

The stock price reflect's the market's assessment of a company's value. A company's value is a measure that depends on its earnings.

So, as earnings increase, the value of that company increases. That's why you see Analysts who set price targets for companies, indicating that a certain company's share price should be $XXX based on its current earnings and predicted earnings trajectory. They derive these price targets from models they create on Excel.

That being said, the average investor does not create an excel model that spits out a company's share price after inputting the company's financial figures. The average investor buys shares of stocks because they believe it will go up into the future. For example, I'm considering buying more shares of AAPL because I believe that they're going to release the iPad 3 in March and it'll be a hit product with great sales.
posted by 6spd at 6:01 PM on February 26, 2012 [1 favorite]

How does holding the stock of a company whose earnings have increased since purchase benefit a stockholder?

A share in a company means you own a percentage of all of the assets of a company. A company with increasing earnings are also, if they are earning a profit, increasing their assets.
posted by empath at 6:08 PM on February 26, 2012

The problem you're describing has been an important critique of the stock market on the political left for some time (and probably on the right as well): stock prices increasingly seem to be decoupled from any actual relationship to earnings / future value at all.

This is a common feature of bubble economies, which the stock market has arguably been since the heady days of the tech boom of the '90s.
posted by gerryblog at 6:10 PM on February 26, 2012 [1 favorite]

When the company's earnings increase, the confidence of the public in that company is higher. Higher confidence means a higher price for its shares.

News that affects a company, negative or positive, will affect the share price even if nothing about the company's actual financials has changed at all, because the news affects the confidence of the public.

Gauging the market's response to these issues is what financial professionals do.
posted by megatherium at 6:14 PM on February 26, 2012

The market cap of a company is the ostensible value of the company. It's the share price divided by the number of shares issued.

I'm an idiot. MULTIPLIED by the number of shares issued. But I guess that's obvious.

The other thing that's less than clear in my toy model is that reinvesting the profit in the company increases the value of the company as a whole. Say the company makes widgets. They make a thousand-dollar profit. The two shareholders can either take home $500 apiece (analogous to a dividend) or buy a better widget-press for $1000. If they buy the $1000 widget press, the company is worth ~$1000 more, or even more than that if the shareholders expect the widget press to increase profits beyond what they paid for it. If Shareholder A wanted to buy Shareholder B's share (ie take full control of the company), he'd have to pay for the current value of B's half PLUS whatever increase in value B expects in the future.
posted by supercres at 6:14 PM on February 26, 2012

The stock price doesn't so much increase a result of an increase in earnings but when earnings have increased more than analysts and/or the company has anticipated. This means that everyone readjusts all those excel models that tells them what the stock is worth sometimes it means that the stock is under-priced compared to future expected earnings.
posted by VTX at 6:17 PM on February 26, 2012 [2 favorites]

Let's say a company has no dividends, but its earnings are $1 billion/yr. It also has one share, and it's trading for $1. Now, what I want to do is buy that stock for $1, take the company private, and keep the earnings for myself!

Of course, that's not going to happen. What's going to happen is that if a company has 1 share, the value would get bid up to the point where it would be in line with other investments that had earnings of $1 billion/yr.

You're buying a stock based on some combination of its earnings and existing assets on the premise that other investors or other companies are going to want to buy it for its assets and earnings. A company whose stock trades at a price that's "too low" considering its earnings and assets will be taken over by a larger company which will want to buy it for its earnings and assets to use for itself.

Buying a stock that doesn't offer dividends is investing in "the future"-- the premise that the the company has expertise and human capital that can reinvest those earnings into expanding in ways that you, as an individual, couldn't. (I trust Apple to use its profits to find better innovation opportunities that will pay off in the future more than I trust my ability to find another company that will do that with Apple's profits if they gave them to me). If a company fails to do this and doesn't reinvest in the company in ways that produce much higher earnings growth than the overall market, then I'm likely to demand that the company start paying a dividend.
posted by deanc at 6:22 PM on February 26, 2012 [1 favorite]

Response by poster: A share in a company means you own a percentage of all of the assets of a company.

I think this gets to the heart of my question. If the company isn't distributing dividends, then why do I care if those earnings and assets are on the way up or on the way down? Why would any potential shareholder care about the earnings of a company if they can't benefit from them in any real way... except to sell the share to someone else who can't benefit from those earnings in any real way? Without dividends, all shareholders are firewalled from earnings yet they all seem very interested in tracking and predicting them.

How about this: Let's say I have a tank in my back yard. I brew beer and I put all my beer into said tank. I sell "shares" in my beer tank. You can buy and sell the beer-shares as you please, but you will never get to drink any of the actual beer itself, ever. In the open beer-share market, why would the price of my beer-shares be affected in any way by projections, rumors, or official reports of how my beer production is going? In fact, why would anyone buy my beer-shares in the first place?
posted by the jam at 6:34 PM on February 26, 2012

Because companies can be bought by other companies, even if they don't have dividends. My company got bought out twice last year, in fact. When that happens, stock needs to be purchased.
posted by empath at 6:39 PM on February 26, 2012 [1 favorite]

the jam: "If the company isn't distributing dividends, then why do I care if those earnings and assets are on the way up or on the way down?"

Because the company might do so later. Or enough shareholders get together and vote the board of directors out for a board that will pay out dividends. Or someone might make a bid to buy the whole company at a premium, and do whatever they want with the cash.

The difference between a company and your beer example is that shareholders can vote your policy down if they feel it's in their best interests to finally tap the keg.
posted by pwnguin at 6:40 PM on February 26, 2012

The question of why stocks should have value is actually a very interesting one and can be as deep as you want to go. I asked almost the exact same question over four years ago and got some great answers. I now trade stocks and equity derivatives for a living and still ponder this question.

The nominal answer is of course that a share of stock represents ownership in the company; if you were theoretically able to amass enough money to purchase all the stock, you would own the company (and its earnings stream). Likewise, if the company were to be taken over, the acquiring company would purchase shares from you (the shareholder). And even if the company does not pay dividends, there is some belief that if in the future the company fails to find a useful way to reinvest its excess cash, it will begin paying dividends.

Take a company like Apple. They pay no dividend. Their market cap is almost 500 billion. They're clearly not getting taken over by anyone anytime soon and they have a huge cash pile. Why should their stock have value? People are asking that question right now expecting that they will start to pay a dividend. In fact, the options market is already pricing in an AAPL dividend for 2012 despite nothing being announced yet.

I'm of the personal belief that the takeover/dividend tie to intrinsic value is very weak and most of the stock value is simply due to what others are willing to pay for it; however, some kind of tie has to be there or the stock truly does have no value. To use your beer tank example, if it was impossible for anyone to ever extract the beer, even if somebody else bought the entire tank from you, and the tank itself had no value, then you are right in thinking the shares would have zero intrinsic value.

There is also a Wilmott thread with some good discussion about this question.
posted by pravit at 7:02 PM on February 26, 2012 [4 favorites]

If the company isn't distributing dividends, then why do I care if those earnings and assets are on the way up or on the way down?

One reason is that, if the earnings go up now and I believe that they will continue to increase at that rate until some time in the future, then it has an impact on the amount of the dividend that the company will pay in the future.

The really simple version is the dividend growth model where current stock value = Dividend one year from now / (required rate of return - Dividend growth rate)

Basically the present value of future dividends.

This formula really only works for mature companies that don't do stock buybacks and are nice and stable. If the company is in growth mode, you can try and figure out what their likely dividend will be when they stabilize, use the formula to work out what the stock price will be when that happens, and then discount that future value to today to get what the stock is worth today.

If earnings were higher than you expected then the potential future dividends increase so today's price increases too. Whether you plan on keeping the stock until they start paying dividends or not, someone will and you might be selling the stock to them or at least you know that someone will somewhere down the line so everyone has to take the future value of the dividends into account.
posted by VTX at 7:09 PM on February 26, 2012 [1 favorite]

How about this: Let's say I have a tank in my back yard. I brew beer and I put all my beer into said tank. I sell "shares" in my beer tank. You can buy and sell the beer-shares as you please, but you will never get to drink any of the actual beer itself, ever. In the open beer-share market, why would the price of my beer-shares be affected in any way by projections, rumors, or official reports of how my beer production is going?

You're right. Why would I put up with that situation? bitr0t took a scenario where you're a crappy brewer. But what if you're a brilliant brewer? Like better than most other brewers, and the market for your beer is wide open. Then you're going to make great beer, and sell it and make lots of money. You COULD give that money to your shareholders, and your shareholders could turn around and try to find another brilliant brewer to invest in. Or....

I could say, "keep the profits and buy more brewery equipment with it and research some new brewery techniques and beer flavors-- you're a brilliant brewer and can do stuff that other brewers can't." You take the profits and do that, and suddenly you're producing even more beer, and it's better and more popular, and you make more money. And then you reinvest *those* earnings from your beer to expand into new markets with your amazing beer and brewery operation. And I think to myself, "this is a great deal! He takes the profits and reinvests them in new ventures that keep giving these amazing returns!" And I look at the numbers and add up the brewery equipment you own, and the stock of beer, and the profits you have in your safe, and I think, "this is worth a lot of money, because he has a much more profitable beer operation that's growing much faster than other companies or assets I could buy" and other people are clamoring to buy my stock. Maybe someone is going around offering high prices for the stock to all the stockholders, because he wants to buy the brewing equipment, the unsold beer in the tank from this year, the profits that haven't been reinvested, and wants to have the brilliant brewing R&D team you've assembled working for him.

Or a few years down the road, the market might be pretty crowded, and you might qualify as a "pretty good" brewer. That's fine, too. And maybe I was one of your early investors, and I only put up $1000, that's now worth $1 million, now, and your earnings mean I'd make $10,000/yr in dividends. Not a great rate of return for a $1 million investment, but very good considering my initial $1000 investment. And I'll be happy to let you keep some of the earnings to expand, but I'm pretty sure that your rate of growth is going to be relatively moderate, and I can use that $10,000/yr to go in search of other high-growth investment opportunities.

It all gets down to whether I think your company will be able to make better use of the earnings than I can.
posted by deanc at 7:49 PM on February 26, 2012 [3 favorites]

As most commenters have pointed out, you care about earnings because that is how companies make money and as a shareholder you have a stake in those earnings.

Companies can return earnings to their shareholders in three ways:

1.) They can use the earnings pay dividends. This is the old-fashioned way.
2.) They can use the earnings to buy their own stock back on the open market. This reduces the number of outstanding shares and increases the value per share. This is sometimes more desirable for tax reasons.
3.) They can use the earnings to buy goods and services that the company is suited to converting into more earnings. I.e., re-invest it.

Imagine a company that has a patent on a highly coveted widget. It has a factory that can produce a million widgets per year at a cost of $100 per widget, but the widgets sell for $200. Each year the company takes in $100 million in profit.

As a shareholder, you can vote on one of three choices: pay a dividend, buyback their own stock, or buy a second factory for $100 million so that next year they can make two million widgets and make $200 million in profits going forward.

The first gives you actual spendable income, which is nice, but you have to pay taxes on it now, and maybe you don't need the money right now.

The second directly increases the value of your shares, giving you the option of selling the shares or holding onto them, which might be preferable for tax purposes.

But if the company has an opportunity like number 3, you probably would prefer they did that, because in the long run that will make them much more money, which means more dividends or buy backs.
posted by justkevin at 8:40 PM on February 26, 2012 [3 favorites]

As justkevin hints, dividends are more common than you'd think. They are just often structured as stock buybacks for tax reasons.
posted by _Silky_ at 8:54 PM on February 26, 2012 [1 favorite]

i don't have much to add other than: the reason ownership matter is that if the company were to go out of business, the money for all the stuff left over would be divided among the shareholders.

to answer your question, you need to also think about bonds. bonds are a loan to a company. if you have a bond, you are "first in line" to get your money back, but you are limited in the amount you can get back. with a stock, there is theoretically no limit to the amount you can get back, but you have to stand in the back of the line. if all the money is gone by the time you get to the front you get nothing.

it's easiest to think of the line metaphor in terms of a company going out of business, but it also works if you think about a company needing X% to stay in business and leaving 100-X% left to be paid out among the bond and share holders in the same matter as before.
posted by cupcake1337 at 11:23 PM on February 26, 2012

Oh, man I know exactly what you mean. I actually worked at a finance firm for 2.5 years in equity research valuing companies and writing reports about whether to buy or sell, etc, but I ended up quitting to do software development in part because I couldn't understand at an intuitive level why it mattered if you owned shares of a stock if they didn't pay dividends.

Say you bought some shares in a tech company ten years ago. It grew like crazy from $100M revenue to $10B and then gradually lost market share and went bankrupt. It was a wild ride and the stock price went way, way up, and then way, way down, but in the end, we see the true value of a share of that company all along was $0, whatever its earnings were. Is that kind of what you're getting at?

Now, it's easy to understand the worth of a share of stock as the net present value of the stream of all future dividends. Even if it's not giving out dividends now, if I expect a share of stock to give me $100 in dividends in five years, I should be happy to pay, say, $50 for it now, right? So to the extent that better than expected earnings causes you to revise upwards your expected future dividends, that will understandably cause the price to rise.

However, with a lot of companies, tech in particular, dividends are nowhere on the horizon, and whenever I spoke with my finance colleagues it was never a criterion in their valuation at all.

There has only ever been one caveat that made this whole thing kind of understandable to me: other companies. While the earnings of the company I own stock in don't matter to me in any real way, they do matter to another company that might want to take it over. Those earnings will go straight to the purchasing company's bottom line. If company A has a profit of $100M a year and swears it will never, ever give out dividends, then at a naive level I shouldn't care about it since none of that profit will go to me. However, if the outstanding shares of company A have a total value of only $50M, then it would make sense for company B (or anyone really with that kind of money) to swoop in and buy it all, because that $100M is now part of their earnings. So, I might buy some shares of company A, just so company B then has to buy them from me, at a markup of my choosing.

But it's a gamble, because not every company gets taken over by another company.

So to answer your question of why increased earnings makes the stock price go up: It could cause you to increase your estimate of the net present value of the future stream of dividends. It could increase the probability you assign that another company is going to buy out this company or pay more for it with the same probability as before. It could be some other rational response which I haven't thought of (but would love to know). Or it could simply be the greater fool theory.
posted by losvedir at 7:21 AM on February 27, 2012 [1 favorite]

I don't know if this really adds anything but I thought of one more way to think about this.

Let's say that you own a big company. No debt, just equity and you own it all, you're the only shareholder. Now, you can take your companies earnings and pay it all to yourself as dividends now, you can keep all the earnings in the company (the "Retained Earnings" account if you look at a balance sheet), or some combination of the two.

What you do doesn't really make any difference to you because "someday" you'll retire and convert all the company's assets into cash and pay yourself a giant dividend. Since your company is pretty good at what it does and gives you a better return on the money you put into the company (return on equity, the company's earnings divided by the money you invested in the company, not based on some fluctuation in the value of the stock) so you generally prefer to leave the company's money invested in the company. If that changes, you would liquidate now and take the money and invest it in whatever other thing would get you a better return.

Now I enter the picture, I'd like to buy your company right now so I ask what it will cost me to buy your company from. You plan on retiring 30 years from now so your company is worth the net present value (NPV) of all of your future earnings for the next 30 years. There might be some consideration of the value of the company's assets (factories and such) but really, the company is worth the present value 30 year's worth of future earnings. It doesn't matter if those cash flows are in the form of dividends or retained earnings since "someday" the whole thing gets cashed out anyways.

Now, if the price I offer you is the same as you NVP of future earnings, financially speaking, it doesn't matter to you if you take the offer or not. If the offer is higher than your NPV, you'll want to take the offer (assuming you know better than I do). I might do that because I think I can run the company better than you or maybe I'm going to combine it with a company I already own and save money from combining HR departments or maybe I'm going to retire and liquidate in 35 years so I'm adding up a few more year's worth of earnings.

If you sit and stew on the offer a little bit and pass the end of your fiscal year. I probably already have copies of your financial statements for the past few years and used those to project what I think your earnings will be for the next 30 years. Now I'll probably want the latest one too. If the earnings are higher or lower than I expected them to be, my projections for the future earnings would likewise go up or down and the NPV of the company will go up or down as result as will my offer.

The difference with a publicly traded company is that we assume (often dangerously so) that it will continue to exist forever unless they give us reason to think otherwise. Earnings made in 2050 aren't worth much in today's dollars anyways so once you start projecting out past ten years or so only really big changes in expected earnings make changes in the present value. We also split up the ownership among a bunch of owners and someone is always looking to sell their ownership stake and it's always worth their share of the NPV of future earnings.

There are more ways to figure out what the NPV of the future earnings are than you can shake a stick at (The dividend growth model is probably the most basic and crazy, huge flaws) and there are lots of arguments about what really constitutes "earnings" (net income, free cash-flow, etc) but it's generally about the present value of some future economic advantage (asset growth, actual cash, capital, etc). Someone is always selling their ownership stake and they always demand the present value of their share of those earnings. Changes to the expected earnings change that value.
posted by VTX at 12:21 PM on February 27, 2012

Don't overlook the purely psychological explanation: When earnings go up, historically this has been a Good Sign, historically people buy stocks with higher earnings, bidding up the price of the stock. Hey, look! This company's earnings just went up! I bet that will happen with this stock too! I think I'll buy some shares....
posted by exphysicist345 at 4:47 PM on February 27, 2012

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