Matt Franz : Zealous For Knowledge

How do stock prices change?

Note: Below is a simplified model of stock prices. Remember, all models are wrong, but some are useful. It is better to be roughly right than precisely wrong.

A stock’s price changes in response to three variables:

  1. Net Income
  2. Shares Outstanding
  3. P/E Multiple

Let’s illustrate this with an example. Below is data for Apple.

Net Income48,35159,53123%
Shares Outstanding5,2525,000-5%
P/E Multiple171914%

Over the past year Apple’s net income rose 23%, shares outstanding dropped 5%, and its P/E multiple expanded 14%. Based on this we would expect Apple to have risen 47.8%. Here’s the math: (1+0.23)*(1/(1-0.05))*(1+0.14)-1 = 0.478.

Sure enough, that is exactly what happened. Apple rose from 153.81 to 227.26, a gain of 47.8%.

Now let’s take a look at the same variables but over a much longer time frame. Below is data for Apple beginning September 1994.

Net Income31059,53119,093%
Shares Outstanding3,3575,00049%
P/E Multiple131947%

This data implies that Apple’s stock price rose 18,832%, which is, of course, exactly what happened. Apple shares rose from a split-adjusted 1.20 to 227.26.

Most investors focus on one-year time frames or less. Doing that, you might think that predicting a change in multiple is equally as valuable as predicting a change in net income. But the longer term data shows otherwise.

A change in multiple is linear. And it’s a one time event. No multiple can increase forever. But a consistently rising earnings per share (net income / shares outstanding) is exponential and only limited by the quality of the business.

It’s critical for an investor to contemplate all three variables that affect stock prices, but they do not deserve equal share of mind. In the short term, P/E multiples can be extraordinarily volatile relative to net income and shares outstanding. Over time this volatility largely nets out and an investor’s return will closely correlate with the change in earnings per share.

Choosing to be a long-term investor is liberating: you can largely disregard changes in multiple in favor of watching the slow but steady changes (hopefully growth) in earnings per share. It’s not as exciting, but it is more rewarding.

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