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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 categories:

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 latest quarter.

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 increases.

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 predictable-growth-at-a-reasonable-price strategy.

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.

End

Shawn Allen, P.Eng.,MBA,CMA,CFA

Editor InvestorsFriend inc. (Written and posted here approximately 2002)

           

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