What Causes Stock Prices To Increase?
All Investors hope that every stock that they buy will increase in price. But
few investors understand much about what would cause a stock price to increase.
Mathematically, we can divide all stock price changes into just two
1. A stock's price can change because its multiple(s) change. This means that
stock traders change their view of what a stock is worth without any underlying
change in the stocks achieved revenues or earnings. For example the (trailing) P/E ratio
or multiple changes, or the Price to Book value ratio changes. Generally this
means that the outlook for future earnings has become more positive or more
negative or the required rate of return on the stock has changed.
2. A stock's fundamentals change as a result of releasing updated financial
data. For example the stock's book value, trailing 12 months revenue or trailing
12 month's earnings changes when it releases financial performance for the
Category 1 (multiple changes) are responsible for almost all of the
day-to-day, minute-to minute, movement in stock prices.
Category 2 (fundamental growth) is responsible for most of the long term
change in a stock's price over a period of years.
This creates two major categories of ways to make money from stock price
1. You can look for stocks that seem under-valued based on their multiples. For
example a company with a strong earnings outlook that is trading at (say) 10
times earnings and (say) 1.5 times book value could increase rapidly in price
due to a "multiple expansion". For example the market could suddenly recognize
that the stock is under-valued and the P/E could jump from 10 to 20 as the stock
price doubles. If you buy this stock at a P/E of 10 and then it rises to a P/E
of 20, you have effectively out-smarted the investor who sold it. The company's
fundamentals may not have changed but the market's view of what the company is
worth has simply increased. This is classic value investing and generally
involves buying stocks with low multiples.
2. You can buy stocks of companies that seem likely to grow their earnings
per share over time. These could be stocks in growth industries. Or it could be a
successful market leader in a mature industry that has a history of growing
earnings at a reasonable and steady pace. For example Canadian banks have, on
average, increased their earnings per share and book value per share over the
years. It seems reasonable to assume that this will continue into the future. If
you buy a share of a Canadian Bank now at a P/E multiple of say 14, then you can
be reasonably confident that over a long period of time such as 5 to 10 years,
the Bank's earnings will grow and therefore the stock's price must rise if the
P/E remains the same.
Often companies with very high expected growth trade at high multiples such
as 50 times earnings or more. In this case the investor is hoping that the
earnings will grow very rapidly and therefore the stock price will rise even if
the P/E multiple falls back somewhat. This is classic growth stock investing and
generally involves buying stocks with high multiples.
Some investors combine features of both strategies.
Warren Buffett , the world's most successful investor, is known to look for
companies that he is very sure will grow relatively rapidly for at least 10
years. He does not necessarily require the company to grow at exorbitant rates
because that is unrealistic for large companies. He looks for companies that
will predictably grow at an acceptable rate such as 10% to 20% per year. Warren
teaches that companies that grow predictably are those with strong competitive
advantages. He often looks for strong brand names like Coke and Gillette and
American Express. And his chosen universe of companies often grow while paying a
healthy dividend. Warren then will only buy these companies if they are
available at a reasonable price multiple. Essentially this is a
I am increasingly of the view that this
predictable-growth-at-a-reasonable-price strategy is an excellent strategy for
investors. It forces investors to try to restrict their purchases to good
companies that are available at good prices. This avoids the common mistake of
value investors of buying bad companies at what appear to be very good prices.
Bad companies can often continue to deteriorate and destroy value. Buying a
stock at 6 times earnings is no bargain if earnings are about to disappear. This
strategy also avoids buying growth stocks that are very unpredictable. Buying a
stock that may grow at 1000% or that may go bankrupt, depending on how things
work out, can often be a painful experience. Finally, this
predictable-growth-at-a-reasonable-price strategy avoids buying good companies
at overly inflated prices. Buying a stock that grows at 20% per year can be a
bad investment if the price you paid was implicitly assuming 30% growth.
Shawn Allen, P.Eng.,MBA,CMA,CFA
Editor InvestorsFriend inc. (Written and posted here approximately 2002)