Certainly, anyone who tells you they know for sure that a share price is going to rise or fall can comfortably be ignored. They don’t. However, there are certain things that influence share prices over the longer term, and you can give yourself a fighting chance of picking better investments by knowing what they are.
Shares are just tiny little chunks of a company. Therefore an important part of how share prices behave is the performance of the company itself. Is it selling more of its products? Is it making more profit from those sales? And to what extent is it passing on those profits to its shareholders via dividends?
Investors may also ask themselves whether the company is run by a strong and capable management team; whether there are any big risks looming that might derail the company; and whether it takes care of its employees. All these can help build a picture of whether a company is likely to grow its profits in future.
There are various metrics to measure these ‘fundamental’ aspects of a company’s strength. For example, an investor might look at revenue growth – how much the company has grown its gross income over the past 12 months. The fund manager’s favourite is a calculation called ‘EBITDA’ (or ‘earnings before interest, depreciation and amortisation'). This, alongside earnings per share, is a way of demonstrating how quickly a company is growing.
Revenues shouldn’t be looked at in isolation, as it is possible to sell lots of products and make little profit. Instead, investors should look at revenue alongside profitability and cashflow. Dividends can also be an indication of a strong company – if a company is generating enough cash to pay dividends to shareholders that is generally a positive sign.
The share price of a company also reflects investor expectations. A company could be selling lots of products and growing its revenues at 50-100%, but if most investors know that, it will be reflected in the share price today. Therefore, continuing to grow earnings at 50-100% won’t push the share price higher tomorrow, as it’s already accounted for.
However, if a company is expected to grow at 50% but suddenly grows at 25%, investors are likely to conclude that it isn’t worth the current share price and sell out. The share price will drop as a result. In contrast, if a company is expected to do badly, and does less badly, then the price may rise. In this way, apparently good companies may do badly in terms of share price, and bad companies may do well.
In judging this, investors often look at the ‘price to earnings’ ratio. This tells an investor how much the market is willing to pay per £1 of company earnings. It’s calculated by taking the share price and dividing it by the earnings per share. If a company is trading on a P/E of 20, it means investors are paying £20 for £1 of profits. If the share price doubles, but earnings stay the same, the P/E would be 40, which doesn’t look quite such good value.
In the long-run, share prices should ebb and flow with the fortunes of individual companies. However, those fortunes are influenced by what is going on in the wider world. If the US economy is deteriorating, that can mean companies will struggle to sell as many goods and services to American consumers. This is being seen in the UK at the moment: the share prices of UK retailers have been under pressure because investors believe Brexit may influence spending habits. This may or may not be true, but no-one wants to take the risk.
The problem is that stock markets are prone to seeing more risks than there are in reality, and this accounts for a lot of the volatility in markets. Investors panic about Chinese manufacturing, or Donald Trump’s access to the nuclear codes, and markets sell off. Often these factors don’t end up affecting the profits of, say, Unilever very much at all and the share price recovers, but it can be painful in the interim.
What should investors conclude from this? Laith Khalaf, senior research analyst at Hargreaves Lansdown, says:
“Valuing a share is not an exact science, and investors need to look at financial metrics but also consider the wider prospects for the company and the sector it sits in. If you’re investing in individual shares you’ll inevitably pick some losers as well as winners, which is why you should keep a diversified portfolio so all your eggs aren’t in one basket.”
We couldn’t say it better ourselves.
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