Drivers of Stock Market Values

Stock market volatility has become a daily reality. Why, how and whether you invest in the stock market is your business. What I usually try to do is provide some information on suggested ways to consider stock market investing, and that is what I will be doing now.

There are many things that affect the value of stocks — too many to sensibly grasp and use to determine what stocks to buy, so I suggest simplifying your decisions by investing through mutual funds. There are many types of funds somewhat complicating the process, but there are much fewer funds than individual stocks, so that makes it a little easier to own stocks. Funds also provide a level of diversification. However, no matter how you choose to invest, there are overall market risks that are very hard to be insulated from.

I have a few rules that I present as suggestions of things to consider. One is to only invest in the stock market if you have a long-term horizon or goal. I define long term as a minimum of seven years, personally preferring ten years as the minimum period. Anything less leaves you too susceptible to wide short-term swings, which we are going through at the present time. Having that longer timeline allows a period for temporary drops to recover. This doesn’t mean it will recover, but if it does, it has time as an ally.

I also tell clients and readers of my blogs that if they like to trade stocks, buy or sell options or if they want to limit their investing to specific sectors or types of stocks, I am not someone they should retain or listen to. My advice is somewhat conservative, geared to people concerned about securing their long-term financial future, keeping in mind that we are dealing with a moving target, and while a sound, thought-out plan is essential, it also needs to be regularly reviewed and have some flexibility. Also, while asset accumulation and growth are very important, people spend cash flow, which has to be integrated into the planning.

Now, let’s consider what drives stock values. Earnings do. Both present and future earnings, the sustainability and/or growth of those earnings and their predictability. Not all companies have earnings, but their expectations of them, at some point, need to exist. I consider earnings the primary driver of stock values. How they are evaluated is a different issue, but earnings are, or should be, the starting point.

Another driver of stock prices is the price-to-earnings ratio (PE). This is a multiplier of earnings. If a stock earns $10.00 per share, the price is $200.00 it has a PE of 20. If that same company had a 30 PE, the price would be $300.00, and with a 10 PE, the price would be $100.00. Usually, stocks expected to grow quickly, or a lot would have a higher PE. Stocks not expected to grow beyond anything out of the ordinary would have a lower PE. I believe that over long periods of time, i.e., ten years, most stocks’ PEs will revert to the mean. This means that the PE will tend to normalize. My sage advice is that this happens sometimes and doesn’t happen sometimes. However, if you track many individual stocks over time, you will see that this occurs more times than it doesn’t. I could write many blogs about this and have. You can go back to one of my first ones in May 2012. I’ve had a number of follow-up blogs to this, basically to confirm what I wrote, including this follow up in 2014. The principles expressed are as valid now as when I first posted them.

A thing about PE ratios is that they can change for the company, the industry or sector, and the entire market. Why they change is a long story, but everything about a company can be great and can be going up, but the overall market could be in a low PE phase, which would push that stock’s PE lower, making the stock go down. The PE is a major driver of value and most people really do not understand it as much as they should. It also is based on earnings, my primary driver.

The next driver of value is dividends. People invest to get a return on their investment. Stock returns come from increased stock prices and dividends. If the stock is a more mature company, translated as stodgy, its earnings might not grow that much, so they need to pay higher dividends to support the stock’s price. Hey, there is nothing wrong with this. Many people need the cash flow the dividends provide to maintain their living standard, i.e., spending. Interest rates in the overall economy also can play a role in a company’s decision on how much dividends they need to pay.

Not all companies pay dividends and then the sole expectations have to be growth in the stocks’ prices. However, keep in mind that while you are waiting for that growth to materialize, you are earning nothing. You also might be paying a price for those shares today that would be reasonable in 5 or more years, so you are buying the stock today at tomorrow’s price. Further, every stock purchased removes an opportunity to buy something else. If the wait could be a number of years, I suggest you evaluate that purchase while considering foregone opportunities.

Stock buybacks also play a factor. When a company buys back some of its shares, they feel they could get a better return investing in their own stock rather than investing the money elsewhere. What also happens is that a lower number of shares then becomes outstanding (the denominator of the equation), increasing the earnings per share. The earnings pretty much remain the same (the numerator of the equation) and when the PE multiple (assuming the multiple doesn’t change) is applied, the price of the stock goes up. This is a simplistic explanation but should make you aware of this pretty common process.

Another factor that most people do not think about except when they meet with their accountant to have their tax returns prepared is the income taxes on any gains. So, tax rates also play a role because at the end of the day, it is the net kept from the stocks, not the amount earned, that determines what you made. If you invest through a tax-deferred or sheltered account such as an IRA, then taxes do not play a current role.

There are other value drivers such as inflation, the value of the dollar, government and individual debt, portfolio and investment costs, politics, and government stability. Corporate governance, individual needs, your health and many other issues that you might or might not be aware of.

To put everything together, keep in mind that a reason for investing in the stock market is to share in the growth of the economy, as that growth is reflected in the prices of a well-diversified investment portfolio. And the purpose of investing is to attain your ultimate financial security.

Now, what does any of this have to do with today’s rollercoaster stock market? Plenty and nothing. Stock prices plummeting is always very upsetting. However, if you have a sound plan that you monitor and a well-diversified portfolio that also provides the cash flow you need, then over a long period of time, i.e., a minimum of ten years, things should be on track. What is happening today is a bump on the road, but you should get to where you need to be unless there is an unforeseen major change in the world and this country (of which we have recently seen two such events – COVID and the war in Ukraine).

There is a lot to consider. On some level, earnings [current, projected or eventually expected earnings] are a primary driver of stock prices. However, while this is so for most stocks, it Is not for all stocks, but I believe it should be. There are also exceptions to everything. I tried to provide a basis for some of the specific things that directly affect stock prices, but you need to watch your investments, be aware of what is going on and understand how stock prices are determined.