How Do Profits Reflect Stock Prices?
Company profits, called earnings, make a stock more valuable
Jupiterimages/Comstock/Getty Images
A company that is profiting from its product or service is more likely, but not guaranteed, to see the price of shares of company stock rise. Profits, called "earnings" on Wall Street, help investors know which companies are successful, which generally makes the shares more valuable and boosts their price. However, shareholders don't see any of this profit unless a company pays a dividend on the stock or buys some stock back from investors, which is an incentive many offer to encourage investors to buy shares in the company.
Tip
Increased profits can cause the stock price to rise as investors feel more confident about the company's future and demand for the stock increases. The issuance of dividends and stock buybacks can also result from profits and increase the stock price.
How Stock Returns Work
There are three ways stocks produce returns for shareholders. Stocks can pay a dividend, which is a cash payment to shareholders. Shareholders can earn capital gains by selling the shares at a higher price than they paid. Also, another company can purchase the outstanding shares in order to complete a merger, which usually results in a better stock price for shareholders than the market is offering.
Quarterly Earnings Reports
Earnings can influence stock price by changing market perceptions and investor confidence of the company. Companies issue quarterly earning reports that reveal the company's profits as measured per share. Before earnings are released, stock market analysts have issued estimates for what they believe a company's earnings will be, which they have calculated based on company guidance, market conditions, management performance and other models and metrics that help forecast performance.
If a company's earnings are more than analyst estimates, it has "beaten the street," and its share price often jumps. The stock price of a company that fails to meet earnings estimates often falls due to failing investor confidence in the company's ability to generate profits.
Stock Dividend Payouts
Positive earnings reports help increase a stock's value even if the company doesn't offer a dividend. Companies often reinvest earnings back into the company to help spur growth, which will be signaled by future positive earnings reports. Profitable companies will eventually have grown enough to no longer need significant reinvestment and will return a portion of their profits back to stockholders through a dividend or by buying stock back from investors. Companies offer these dividends as an incentive to encourage investors to buy shares of their stock.
The Price-to-Earnings Ratio
While earnings reports and estimates are important factors in stock price, other conditions can also change how the market prices a company's stock. Company financial statements contain information on assets, debts, cash flow and other performance data that can move a stock's price. Company news, such as a new product release or a product recall, can also affect the stock price.
The supply and demand of a stock also affects its price, showing that investors will pay for a stock that promises future growth and earnings. The market's perception of a stock's price is reflected in the price-to-earnings ratio, which is the stock's share price divided by its earnings-per-share. Investors often use this ratio to determine how "cheap" a stock is by looking at how much it costs to buy $1-per-share in earnings.
References
Writer Bio
Terry Lane has been a journalist and writer since 1997. He has both covered, and worked for, members of Congress and has helped legislators and executives publish op-eds in the “Wall Street Journal,” “National Journal” and “Politico." He earned a Bachelor of Science in journalism from the University of Florida.