Stock Market Tutorial – Part 2 – What Determines Stock Price – see below

This stock market tutorial explains all about the most important ratios used to determine which stock to buy and which to avoid.

To assess a company and hence it’s stock, it is an advantage to know some of the fundamentals, on which the company measured by.
When assessing whether a listed company is worth investing your money, there are some ratios that are interesting. These ratios are particularly useful because you can compare them with companies that would not otherwise be comparable at all. Ratios provides a quick overview of some of the basic conditions that determine whether a company is doing well or not – and whether you should buy stocks in the company or not. After reading this stock market tutorial, make sure to read the other stock market tutorials as well.

Profit margin
This is the most important metric. The figure is obtained by dividing the operating profit with turnover. Hereby is obtained a percentage that says something about how good the company was to make money in that period.

Example:

Turnover: $100 million

Profit: $10 million

Operating margin: (10/100) x100 = 10%

The company earned $10 every time there was a turnover of $100.

The figure can be readily compared with its competitors.

The various industries are operating with very different degrees profits – trading with a large turnover has typically a very small margin (1-2%), while e.g. pharmaceutical companies often have very large margin (20-25%)

Return on equity
This figure says something about the company’s profitability and it is obtained by dividing annual profits before tax  with the equity. Equity in this context, total deposits of shareholders in the company.

By comparing the evolution of this ratio over time, you can get an idea of how well the stock performs. If the ratio rises, it is positive – if it decreases it is negative.

P/E = Price-Earnings Ratio
P/E ratio is another useful indicator, which appears in the newspapers stock listings. It is obtained by dividing the company’s market capitalization with annual profits after tax, and it says something about words, how much return you get per share.

Example:
The company has issued one million shares, with a price per share of $150. This provides a market capitalization of $150 million.

If after-tax profits were $30 million, the P/E ratio is calculated as follows: 150/30 = 5

As a general rule, P/E values typically fall between 10 and 15, while the figure for the most promising companies can be as high as 20-30 if there are high expectations for future earnings.

A P/E of 5 as in the example is, in principle, an indication of good earnings per share. Is the P/E ratio very low, it indicates that the market is skeptical, but which can in turn make big gains if the company’s earnings outlook suddenly changes for the better.
There can be large differences in P/E value in various industries – real estate typically have a low P/E while pharmaceutical companies have a high P/E value.

A higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

P/B (Price/Book value)
An interesting figures – not least at the moment. The price of the share in relation to the intrinsic value (P/B), obtained by dividing the company’s market capitalization by its book equity.

The figure says something about how the market assesses the stock relative to the company management itself has estimated that it’s stock worth.

Good, healthy companies are typically traded with a P/B value which ranges from 1 upwards. Very promising companies can have an stock value that is 4-5 times higher than the book value and thus a higher P/B-numbers.

With the current financial crisis, you can several banks, which have a P/B, which is far below than 1.

It is an expression of market skepticism. Investors do not believe that it is worth as much as the company itself has estimated the value of its latest accounts.

Lehman Brother for instance, had a P/B ratio of 0.53 in August 2008 – this could indicate a undervalued stock, but remember, when stocks go on sale, it is only a good deal when the value you receive is greater than the price you pay!

Make sure to check out other stock market tutorials on this site.

Stock Market Tutorial – Part 2 – What Determines Stock Price

What affects the stock price?

The price of a stock is influenced by many factors – and often it is pure psychology.
At first the stock market may seem quite chaotic with prices that goes up and down, apparently without any news that might justify it.

But of course there is a kind of logic in the madness.

There are basically three different factors which contribute to and play a role in the formation of the stock price.

1. The macro economic conditions
2. The conditions in the industry / regional conditions
3. Ratio of the company itself

The macro economic conditions
Macro economics for example in the form of the U.S. economy, oil shocks, political factors such as unrest in major countries, etc. is estimated to affect stock markets by 20-30 percent.

The market reacts negatively when the U.S. is hamstrung by disasters such as 11th September 2001. And when the U.S. invades Iraq, it also infects the world’s stock markets, depending on how to interpret the initiative.

The big fluctuations in the markets is typically driven by the overall economic cycle, as we have seen in recent years with the global financial crisis.

When global growth is falling, then stock pices are also falling because companies sell less. But the stock market tends to anticipate both the joys and sorrows. Market reaction is typically 3-6 months before the impact of an economic downturn can be seen in the general economy.
The conditions in the industry / regional conditions
20-30 percent of the rate is controlled by conditions in the industry or region in a given company is in. It can, for example, act on specific trade restrictions, tax and interest rate conditions.

Often, the price movement could be very different in different industries. There is great variation in how the terms are in different industries at a given time. If we stand in front of a world recession, for example there is not much point in having shares in the automotive industry, because people tend to buy fewer cars in a recession or during economical crises.

If an industry, such as the financial sector, stands ahead of a period where there is opportunity for growth, the big investors start funneling some of their money into that industry, which in turn will cause the price of financial shares to rise.

Being in the middle of a depression with negative growth like the present, many professional investors will, during these periods, have a large part of the funds invested in cash, or they will have them put them into shares that are not as cyclically sensitive (e.g., pharmaceuticals, breweries, basic foodstuffs, etc.).
Ratio of the company itself
Approximately half of the price formation is controlled by conditions in the company itself. Is leadership effective? Is the company doing better or worse than its competitors, are there are good products on the shelves, etc.

But it is not enough to look at their accounts from previous years. The stock market also always looks ahead. The share price of a company does not reflect what it earned last year, but what it probably will earn in the future.

These expectations – and thus formation – occurs in a crucible of objective and subjective parameters. The company’s own statements, rumors in the market, management’s ability to deliver what it promises, competition, etc.

Market Psychology
In the short term (1-3 months) psychology plays a huge role in price formation. If a stock for example falls much over a longer period this can cause panic. More begins to sell out, and it is spreading, so the price falls excessively in a short period. After such a period it might often be a good time buy, because the price has been pushed far down without good reason. Of course, the difficult task is to know when to step in.

Generally, the stock market goes to extremes – like a pendulum swing rates between the two extremes.

For participants in the equity stake and investors living trading shares from day to day, the picture is somewhat more complicated.

A message from a company can trigger an immediate change of direction, and the same can be messages from a rival, a trade organization, a news story in a newspaper, rumors in the market, etc.

If you can interpret these messages and if you are quick, you can sometimes ride on a wave.

Make sure to check out other stock market tutorials on this site.

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