Understanding share prices

The primary driver of a company’s valuation is its ability to grow earnings and eventually dividends. There are a number of ways that a company can increase its earnings over time.

Growing the business - There are a number of ways that a company can increase sales such as entering new markets, entering into partnerships and joint ventures, winning new contracts/customers, developing and launching new or improved products, improving marketing and sales offerings and more.

Raising prices - During positive economic times, some companies gain the ability to charge higher prices for current products as demand increases. This is particularly significant for resource producers during bull markets for commodities.

Cost controls - A company can also improve its profitability by reducing expenses, although those that do run the risk of cutting corners. To measure this, traders often look at expenses such as administrative, sales and marketing, interest, and depreciation as a percentage of sales to determine how efficiently management is running the business. Looking at operating earnings as a percent of sales (margin) can also give an indication of the profitablity of the company.

It’s important for traders to recognize that often the sky is not the limit and that there are also numerous risks that could cause a company to lose money or see business decline dramatically. Fear of negative outcomes can limit the upside potential for shares or even cause declines.

Operating risks - There are many ways that a company’s day to day business can face problems such as machinery breaking down, the entry of new competitors, price wars, input cost increases, adverse economic conditions, lost contracts/customers and more.

Political risk - This varies by country but relates to the potential that a new government could gain power and implement adverse economic policies such as tax increases, new regulations, asset nationalizations, and other initiatives.

Legal risk - This relates to the possibility that the company could be sued. This particularly appears in sectors where there can be disputes over patents and intellectual property which could lead to significant damage awards or injunctions against doing business.

Currency risk - This relates to the possibility that the company could be sued. This particularly appears in sectors where there can be disputes over patents and intellectual property which could lead to significant damage awards or injunctions against doing business.

Bankruptcy risk - In difficult times, companies with high debt levels can find themselves unable to meet their obligations to have enough financing to meet their day to day obligations.

Dividends can also have a significant impact on market sentiment. While earnings can be dependent on accounting estimates, dividends represent a payment of actual cash to shareholders. With equity markets stagnating over the last decade, dividends have become a significant component of shareholders’ income and return expectations.

Some shareholders rely on dividends for income companies that cut their dividends tend to see their shares punished severely by the marketplace, and those that eliminate them entirely tend to lose institutional shareholders restricted by policies of only owning dividend paying shares. Because of this, companies tend to only raise dividends to levels that they feel confident that they can maintain over the longer term.

This suggests that changes to dividends can give a strong indication of management’s expectations of future results. A dividend increase is indicative of confidence, while a dividend cut generally indicates that a company has encountered major difficulties.

One final key note on dividends for traders. Once a dividend is declared, there is a cut-off date for owning the shares to receive the dividend. On the first day of trading where a buyer would not get the dividend, known as the ex-dividend date, the price tends to get marked down at the open by the amount of the dividend.

Corporate earnings reports tend to attract a lot of attention and trading activity for a couple of reasons. First, while some developments may come as a surprise, earnings reports and the accompanying conference calls tend to be scheduled and publicised well in advance, so that traders and media are watching for the results. Second, analysts tend to publish estimates for earnings in advance, so the consensus of expectations tends to be priced into shares ahead of time.

Because of this, trading around earnings reports tends to be less influenced by the actual level of earnings and more by how reported earnings turned out relative to street expectations. Management’s estimates for future quarters, widely known as guidance, can also have a big impact on investor sentiment.

Share trading ahead of a report can also be important. A rally heading into earnings news may suggest growing expectations and a higher risk of disappointment, while a selloff before the news suggests a lack of confidence and the potential for a positive surprise.

With so many traders and media focused on the earnings and guidance numbers there can be significant volatility following the release of earnings data which is why many companies, particularly in the US, tend to report outside of market hours. These reports can have an impact on trends as well and thus can create significant opportunities and turning points for traders.