As far as I understand, the only thing that investor really get from the company’s profit is mainly from dividends. So, all other P/E ratios, fundamental analysis, chart analysis, etc for stock price growth are no better than just looking into a fortune-teller’s crystal ball? Stock prices seems to be almost entirely driven by “market forces” aka what people feel about the company. Whatever those “expert” analysts say seems to be just trying to put meaning into something that really doesn’t actually impact the stock price, not much difference from horoscope? There are many big profitable companies with almost flat stock prices and there are also companies without any real profits but the stock prices skyrockets.
In: Economics
Professional analyst here,
It looks like some of the confusion is about short-term vs. long-term price movements. Some people who believe markets are “efficient” would suggest that the two are very strongly related. A relationship exists, but it isn’t that strong. So what you really need is four parts:
1. Do earnings matter to the short term price?
2. Why?
3. Do earnings matter to the long term price?
4. Why?
1. Quarterly earnings reports have a material impact, but the even larger impact comes from management’s guidance for future earnings.
2. The short term price is very heavily impacted by sentiment. If investors are optimistic, the price goes up, pessimistic and the price goes down.
3. The long term price is still driven by expectations, but it is also anchored more by reality. Let’s take an example. If we can look at a business and be very confident it can continue to cover the dividend and raise it every year, we could start estimating the value of the current payment plus the future growth. This is the arguably the most basic part of analysis.
4. This concept gives people so much trouble, but it is critical to understand. If you owned 100% of a business, all you would care about (in a profit seeking manner) is how much cash it could give you over time. “Earnings” are similar to that cash flow. There are differences, but this is ELI5. So if you are planning to invest for the long term, you want to know how much you are paying today and how much the company will be able to generate for you in each year in the future. Further, you would want to estimate the risks of being wrong. If things don’t go how you expected, how much better or worse might they be?
Your best bet is to learn these parts completely before trying to tie in anything else.
Pretend you would be holding the stock forever. If you plan to sell it in the future, ask yourself what would cause you to buy it in the future instead. Many investors don’t look through the eyes of the other person in the trade. It is a critical mistake. When I’m buying a stock, I want to understand what could go right and what could go wrong. If I see a great deal, why is the market (collective group of all investors) willing to accept that price today?
PS. This was probably more of an ELI12.
Latest Answers