Basic Stock Market Question

[BadgerinATX]

My question is: How are share prices connected to a company's performance?

I think this is one of those questions that can be answered simply or it can be answered in a 200 page paper. My background is nowhere near economics/finance and I'm fairly young yet so this question is purely based in curiosity.

Another thing I'd like to learn about is how a stock reacts to buyouts and mergers.

Anyway, here's my current understanding of items related to my question:

I understand that dividends paid out depend on profits. The shares of a company that's performing well and regularly issues dividends will be in greater demand than one that isn't performing well and/or doesn't regularly issue dividends.

On the other side of the coin, if a company goes under, it's shares are essentially worthless so if that is a real possibility that will devalue a share.

Aside from dividends and going under, what makes the shares of a well performing company desirable and a poorly performing company undesirable?

Also, any comments about the impact mergers and buyouts have on share prices would be interesting.

 

[Jellydonuts]

I will do my best to answer these.

There is typically a correlation between stock price and peformance, with the most basic being the P/E ratio (simply the price of the stock divided by the earnings per share). The faster earnings are growing, the higher the P/E ratio investors are willing to pay. However, other factors will go into the stock price (i.e. any potential distuption in revenues or cost increases, potential mergers, lawsuits, unstable industry and etc).

Dividends do not necessarily mean a company is performing better. They are typically paid by more mature companies, as high growth companies will retain their earnings to finance growth. Companies that pay dividends will typically trade slightly higher than those who don't, but Earnings Per Share is still the main driver of the stock price.

If a company goes under, obviously it will greatly devalue the stock. It will typically begin trading at its perceived liquidation value (what the assets can be sold for) and not based on its EPS.

Typically when a company announces it will buy out another company, its stock price will go down and the target company's will increase. This is because the acquiring company usually issues stock to finance the merger, therefore diluting the existing shareholders (there are more shares out and accordingly each shareholder owns a smaller percentage of the company).

 

[hookem2003]

You are right that this could be a thesis of an answer, but I'll do my best to give you a quick answer.

Each share represents a portion of ownership of a company. The stock price x the number of shares outstanding = the value of the company. That value is present value of what the market thinks all of the company's future earnings are worth in today's dollars( i.e. a dollar 10 years from now is worth less than a dollar today). Obviously, forecasting future earnings requires estimates. As those estimates change, based on the company's performance, the stock price changes.

Today was a good example. Financials (i.e. banks, brokerage firms, etc.) were up today b/c Wells Fargo reported better than expected earnings. Obviously, with everything going on in the financial sector right now, estimates are pretty pessimistic. But now since one bank did better than expected, people think other banks will probably follow suit. Therefore, investors adjusted their earnings estimates, and financial stocks jumped across the board.

Now, there are a million different influences on a stock, but that gets to the core of it.

As for m&a, that moves a stock based on, once again, the changed estimates. Frequently, an acquiring company has to pay a "control premium" in order to get everybody to sell out. Pretty much this is supply and demand - what is a price that, in most cases, the board is willing to supply ALL of our shares? Also, acquirers sometimes pay a premium when factoring in "synergies" - things that make a deal operationally attractive. Another good example this week would be InBev and Budweiser. InBev, hypothetically, is willing to pay a premium over anybody else b/c of things like Bud's distribution network, name brand, factories, etc. that could (1) save them a lot of money (in brewing costs, promotion, etc.), or (2) lead to additional revenue (i.e. places that didn't sell Stella before will now). While this makes sense for InBev, a fellow brewer, if would not have the same effect necessarily for a private equity group or a company in another line of work, therefore they can justify paying more for the company.

I hope that helps.

 

[Stuck_At_Work]

What the guys above said.

But... let me take a different angle.

Stock price is not directly related to corporate performance. It is simply a measure of investor sentiment.

Take Apple. Take their number of shares times the price per share and you get their market cap. Apple's market cap is $172 billion. Apple's Q2 total net income was roughly $1 billion.

Meanwhile, Dell has a market cap of $45 billion. Their Q2 total net income was $784 million.

There are of course other factors... but just looking at these number might leave a little confused. Is Dell under-valued? Is Apple over-valued? You will hear both sides of the argument.

In the end, what drives the stock price is consumer confidence in the stock.

 

[EuroHorn]

If you want to get M&A exposure in the market a pretty good fund is the Merger fund (MERFX). For announced deals, they short the buyer and go long on the acquired company. One risk is if the deal doesn't go through. However, it is a pretty stable fund and kind of fun.

 

[Ignatius]

Also, dividends are generally the product of company philosophy - some pay them when times are good, some religiously don't pay them no matter what. A lot of people think that dividends are a gimmick to keep investors interested - in the end, what you pay out as dividend cash will ultimately deflate (generally to a small degree) the company's cash position, and as such you aren't any better/worse off than if the company didn't pay dividends...

 

[hookem2003]

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[Genco]

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