Earnings Drive Stock Prices

When people invest their money, whether it’s in the stock market, a rental property, or their education, they expect to get a return on their investment. With rental property, the investor expects that the income generated from rentals will more than offset the costs associated with the property, leading to some profit. Individuals who invest in an education will typically pursue a higher-paying career, with the expectation that the additional income will more than balance out the cost of the education.

When it comes to investing in the stock market, the idea of buying low and selling high is well known, but what drives stock prices higher (or lower)? The short answer is earnings, but there’s more to it than that. 

It’s important to understand that when you invest in the stock market through the purchase of a mutual fund or individual stocks, you become a business owner. The amount of the business (or businesses) you own is proportional to the number of shares of stock you have, relative to the total number of shares outstanding. In addition, as an owner of the business, you are entitled to a proportionate share of the company’s earnings. Accordingly, while there are many ways to calculate the value of a business, one of the most important measures is its ability to generate—and grow— earnings, or profits. As a company’s earnings grow, the business expands and becomes more valuable, and the share price increases to reflect that growth.

Another noteworthy consideration is that while earnings are the primary driver of stock prices over the long term, prices fluctuate over the short term as new information about the company, the industry in which it operates, and the broader economy become available—all of which influence investors’ expectations for the firm’s future prospects for earnings growth.

Some of the short-term drivers of price changes can also be more emotionally driven than rationally driven as investors “shoot first and ask questions later.” However, over the long term, business fundamentals that are underpinned by earnings ultimately drive growth (or a lack thereof) in a company and the price of its stock.

In the spirit of earnings season, today’s Chart of the Day takes a look at our First Quarter 2018 Earnings Season Dashboard. As companies continue to report earnings, check back on our weekly updates available every Monday through May.

 

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