This article appeared first on The Stock Market Blueprint Blog.
When it comes to the stock market, one thing is for certain: stocks go up and stocks go down. The question is: what makes a stock go up or down?
What makes a stock go up or down is determined by the recent operating results of a business and its future expectations.
This means stock prices reflect both fundamentals (operating results) and emotions (future expectations). When either one or both of these change for a particular stock, its price will be affected.
What Makes A Stock Go Up (Or Down)?
It’s impossible to pinpoint exactly what makes a stock go up or down on a daily basis. To borrow a phrase from The Princess Bride, “Anyone who says differently is selling something.”
On the other hand, it’s quite simple to see what makes a stock go up or down over time. Stock prices are based on how investors think a company will perform in the future compared to how the company is performing now.
In any investment, investors are betting on the future. Because the future is uncertain, stocks cannot be priced based on a business’s current operating results alone. They must be valued by predicting future performance.
In order to quantify these predictions, investors use price ratios. Price ratios are simple tools which show how a stock is priced compared to its recent operating results.
For example, a Price-to-Earnings (P/E) ratio of 10, says that a stock is valued 10 times higher than its current earnings.
This does not mean that investors expect the company’s earning to increase by a multiple of 10 in the near future. It merely means that if the earnings were to stay constant, investors would break even on their initial investment after 10 years. In other words, the earnings yield on the principle is 10% (10/100 = 0.1).
Say a stock has a P/E of 50 and investors still expect to receive an earnings yield of 10%. Paying 50 times earnings only makes sense if the company’s earnings are expected to increase substantially over time.
No matter how badly stock analysts pretend to be fortune tellers, no one can accurately forecast a company’s future performance (especially on a consistent basis).
Charles Duhigg, in his book Smarter, Faster, Better: The Secrets of Being Productive in Life and Business, summarizes the reality of what the future is. Duhigg says, “The future isn’t one thing. Rather, it is a multitude of possibilities that often contradict one another until one of them comes true.”
These multitude of possibilities are what cause price ratios to fluctuate so often for any one stock.
Although there are countless numbers of possible futures when considering a stock investment, there are really only three general scenarios.
Scenario #1: A company’s operating results will increase.
Scenario #2: A company’s operating results will remain constant.
Scenario #3: A company’s operating results will decrease.
The level of a stock’s price ratios is determined based on which scenario investors anticipate will come true for that particular stock.
Scenario #1: High price ratios.
Scenario #2: Average price ratios.
Scenario #3: Low price ratios.
Before getting too focused on price ratios, it’s important to remember that change in operating results is the second half to determining what makes a stock go up or down.
Say a stock is reporting earnings per share (EPS) of $5 and has a P/E of 10. The stock would be valued at $50 per share ($5 x 10 = $50). Then, the company unexpectedly reports EPS of $5.50. If the P/E stays at 10, the stock is now valued at $55 per share.
To summarize, stock prices go up or down depending on changes in operating results and the levels of its price ratios.
The interesting thing is that changes in operating results most often trigger changes in price ratios.
Because the future is hard to predict, operating results often differ (sometimes greatly) from what investors expect them to be. When a surprise like this happens, future expectations are reconsidered and price ratios are modified.
Impact of Surprises
In David Dreman’s book, Contrarian Investment Strategies: The Psychological Edge, he notes the impact of such surprises. Here is Dreman discussing the market’s reaction to unexpected results:
“Several researchers have found that when a company reports an earnings surprise (that is, a figure above or below the consensus of analysts’ forecasts), prices move up when the surprise is positive and down when it is negative.”
It makes intuitive sense that stock price adjustments correlate with positive or negative surprises.
Not only do the surprises reveal a change in operating results, but the change in operating results affect the future expectations of the company.
This explains why value stocks (low price ratios) outperform growth stocks (high price ratios) over time.
Value Goes Up, Growth Goes Down
Low price ratios anticipate negative futures (decreased profits) and high price ratios anticipate positive futures (increased profits). Therefore, stocks with low price ratios have more upside potential. On the flip side, stocks with high price ratios have nowhere to go but down.
In Contrarian Investment Strategies, Dreman references several studies which show that positive surprises impact value stocks greatly but only minimally affect growth stocks. The studies similarly show that negative surprises impact growth stocks greatly buy only minimally affect value stocks.
Here’s Dreman explaining the impact that both positive and negative surprises have on growth stocks:
Growth Stocks: Positive Surprises
“Since analysts and investors alike believe that they can judge precisely which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations.”
Growth Stocks: Negative Surprises
“Investors expect only glowingly results for these stocks. After all, they confidently –overconfidently – believe that they can divine the future of a ‘good’ stock with precision. Those stocks are not supposed to disappoint. People pay top dollar for them for exactly this reason. So when a negative surprise arrives, the results are devastating.”
And here’s Dreman explaining the impact that both positive and negative surprises have on value stocks:
Value Stocks: Positive Surprises
“Those stock moved into the lowest category precisely because they were expected to continue to be dullards. They are the dogs of the investment world and investors believe they deserve minimal valuations. A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice. Maybe, they think, these stocks are not as bad as analysts and investors believed.”
Value Stocks: Negative Surprises
“Investors have low expectations for what they believe to be lackluster or bad stocks, and when these stocks do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event.”
Fundamentals Change Expectations
These scenarios explain why value stocks have nowhere to go but up and growth stocks can only go down.
If a value stock’s fundamentals unexpectedly increase, not only will its operating results improve, but investors’ future expectations will be raised as a result.
Contrarily, a growth stock’s fundamentals are already expected to increase. Any improvement in operating results is already priced into the stock.
Decreased operating results are already priced into value stocks but not growth stocks.