Although we are using earnings per share (EPS), an accounting measure, to illustrate the concept of earnings base, there are other measures of earnings power. Many argue that cash flow-based measures are superior. For example, free cash flow per share is used as an alternative measure of earnings power.
The way earnings power is measured may also depend on the type of company being analysed. Many industries have their own tailored metrics. Relatively mature companies are often measured by dividends per share, which represents what the shareholder actually receives.
The valuation multiple expresses expectations about the future. It is fundamentally based on the discounted present value of the future earnings stream. Therefore, the two key factors here are 1) the expected growth in the earnings base and 2) the discount rate, which is used to calculate the present value of the future stream of earnings. A higher growth rate will earn the stock a higher multiple but a higher discount rate will earn a lower multiple.
What determines the discount rate? First, it is a function of perceived risk. A riskier stock earns a higher discount rate, which in turn earns a lower multiple. Second, it is a function of inflation (or interest rates, arguably). Higher inflation earns a higher discount rate, which earns a lower multiple (meaning the future earnings are worth less in inflationary environments).
In summary, the key fundamental factors are:
The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends per share)
The expected growth in the earnings base
The discount rate, which is itself a function of inflation
The perceived risk of the stock
Things would be easier if only fundamental factors set stock prices. Technical factors are the mix of external conditions that alter the supply of and the demand for a company’s stock. Some of these indirectly affect fundamentals. (For example, economic growth indirectly contributes to earnings growth.) Technical factors include the following:
We mentioned inflation as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies.
Economic strength of market and peers
Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements - as opposed to a company’s individual performance - determines a majority of a stock’s movement. (There has been research cited that suggests the economic/market factors account for 90 percent).
Companies compete for investment rupees with other asset classes on a global stage. These include corporate bonds, government bonds, real estate and foreign equities.
Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often prescheduled or driven by portfolio objectives.
Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official ‘votes cast’ for or against the stock, they do impact supply and demand and therefore, can move the price.
Some important research has been done about the demographics of investors. Much of it concerns these two dynamics: 1) Middle-aged investors, who are peak earners that tend to invest in the stock market and 2) older investors, who tend to pull out of the market in order to meet the demands of retirement.
The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples.
Often a stock simply moves according to a short-term trend. On the one hand, a stock that moves up can gather momentum, as ‘success breeds success’ and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean.
Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are ‘trendy’ does not help us predict the future. (Note: Trends could also be classified under market sentiment.)
Liquidity is an important and sometimes under-appreciated factor. It refers to how much investor interest and attention a specific stock has. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community).
Large-cap stocks have high liquidity: They are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent ‘liquidity discount’ because they simply are not on investors’ radar screens.
Market sentiment refers to the psychology of market participants, individually and collectively. This is perhaps the most vexing category because we know it matters critically, but we are only beginning to understand it.
Market sentiment is often subjective, biased and obstinate.
For example, you can make a solid judgment about a stock’s future growth prospects and the future may even confirm your projections, but in the meantime, the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.
Market sentiment is being explored by the relatively new field of behavioural finance. It starts with the assumption that markets are apparently not efficient much of the time and this inefficiency can be explained by psychology and other social sciences.
The idea of applying social science to finance was fully legitimized when Daniel Kahneman, a psychologist, won the 2002 Nobel Memorial Prize in Economics. (He was the first psychologist to do so.)
Many of the ideas in behavioural finance confirm observable suspicions that investors tend to overemphasize data that come easily to mind; that many investors react with greater pain to losses than with pleasure to equivalent gains and investors tend to persist in a mistake.
Some investors claim to be able to capitalize on the theory of behavioural finance. For the majority, however, the field is new enough to serve as the ‘catch-all’ category, where everything we cannot explain is deposited.
Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe strongly in fundamentals can reconcile themselves to technical forces with the following popular argument: Technical factors and market sentiment often overwhelm in the short run, but fundamentals will set the stock price in the long run.
In the meantime, we can expect more exciting developments in the area of behavioural finance since traditional financial theories cannot seem to explain everything that happens in the market.
Source: Investopedia and Automated Trading Rules of the Colombo Stock Exchange)