Wednesday, July 15, 2009

the pricing of stocks

It is time for another question from the Personal Finance Clinic mailbag. By the way, thank you to all who submitted questions for The Personal Finance Clinic. Please visit Canadian Capitalist and Triaging My Way to Financial Success to view the balance of the Q&A.

Ellen asked;
Does it matter whether the value of my stock investments increases because of earnings or increase in value? If so, is there a rough and ready way for me to tell how much of the increase is due to earnings and how much due to price increase?

The simple answers to these two questions are 'No' and 'No'. Let me explain...

First off, you must understand that there is no value without earnings. Any increase in stock value that one might think is unrelated to earnings is a misnomer because it always comes back to earnings and earnings growth. Stock prices will always reflect investor sentiment about the future over the short term. Over the long term a stock's value should come back to reflect the true measure of a company's success, which is earnings per share (EPS). Broken down to it's bare bones, the only thing that really matters to a stock's value is earnings per share, however obviously several other factors will dramatically influence the price. If a food manufacturer just earned a great EPS number for the year but lost two major contracts due to a deadly contaminant in their product, the high EPS will matter very little as the stock is sold off hard.

For example, let's say Gusher Oil & Gas earned $4.00 per share in 2009. You might think the stock should trade for at least $32 per share or so (8x earnings), if the firm was in decent shape and was expected to grow earnings at a moderate pace. In reality Gusher could trade at $16 per share if oil prices are expected to plummet and Gusher had taken on too much high interest debt. On the flip side, Gusher could trade at $80 per share if they just discovered a new oil deposit and oil was expected to rise dramatically in the short term.

A good way to understand why stocks are priced the way they are, and why they move the way they do is to understand the sum of investor's thoughts about the company's future earnings growth potential. This is a complicated mish mash of predictions, anticipated industry trends, past performance, and expectations. At the end of the day every stock price is a guess at future earnings growth.


Sampson said...

This is of course very interesting in light of the near return of Canadian banks to pre-crash levels. No one can convince me that current earnings, and the potential for future earnings warrants these prices.

I don't remember if you've posted on this before, but are you one of the people in the camp that financials will have a very difficult time growing earnings as they did over the past 10 years.

TD has been most aggressive, in the US, but BNS has made a few acquisitions in NA also. I've got a feeling that those companies relying largely on retail banking will make some gains.

MG (moneygardener) said...

It is tough to say. Although increased regulation, a tough economy, and credit losses are headwinds, banks like TD and RY should pick up market share as a result of the failures in the US. I'm in the camp that as the years go on the credit crisis will become water under the bridge (with the exception of the US gov. debt). Good banking will continue to be as profitable a venture as it was during the last 20 years.

indavao said...

hi... just dropping by!

RB said...

What's interesting to note is that Wall St. banks are all planning on paying record bonuses again this year as earnings accelerate. Just look at Goldman Sach's and their $700,000+/employee compensation!

The worst of the downturn is over, just like that. And since there are 20% less people to pay in the financial services industry, and earnings are rebounding, bonuses could be very good this year.

The key is survival. Perhaps when unemployment gets to 15% in the US will the market really start going back in the dumps.