What Drives Stock Prices?

A Look Into the Underlying Forces That Determine How Much Money Investors Make From Their Stocks

Recent years have seen a surge of speculation that, by some measures, looks similar to the dot-com era.  Generally speaking, most investors have made a lot of money, but a few folks have generated absurd returns on what is essentially a non-sustainable momentum trade that, when it turns – and I believe it will – is not likely to end well.  (I remain steadfastly convinced that most of the advantages of large language models are going to go to integrations of existing software platforms and that the frontier models essentially are more similar to airlines in cost structure than the old-line software companies.  Most folks are not running cutting-edge medical research or the like.  Instead, locally run private models are the future because the forces of capitalism cause the cost advantages to become extreme.  Boardrooms will eventually wake up to this fact and I think the landscape looks very different two years from now.  We’ll see.)

In any event, to alleviate my own concern for my fellow man, similar to what I did in the dot-com era and the run-up to the real estate hype prior to the Great Recession, I feel it is important to remind everyone that, at the end of the day, the mechanics that drive wealth accumulation through ownership of stock can be broken down into constituent parts.  If you expressly identify those parts, it’s much easier to confront your assumptions and test them for reasonableness; to separate speculation from investment.

Let’s begin.

The Two Sources of Potential Profit When You Invest in Stocks

There are two sources of potential profit when you make an investment in stocks. They are:

1. Changes in the stock price.  You hope to buy at a low price and sell at a higher price.
2. The cash dividends you receive during the time you are an owner.

Looking at this from an engineering standpoint, we can break down those components into their simpler forms.  What causes those two things?  We can build a cause-and-effect tree to boil down the core actions that result in a stock becoming more valuable or less valuable.

We Can Break Both Into Their Underlying Components to Better Identify the Levers

• Change in the Stock Price – This can be driven over time by:
  • The Absolute Amount of Diluted Earnings per Share, Which Can Be Approximated As*:
    • Book Value per Share x Return on Equity
      • Return on Equity can be broken down either into three components, multiplied together, which are …
        • Net Profit Margin (Net Income ÷ Revenue)
          • Profit Margin is Profit ÷ Revenue.
          • Profit is Revenue – Expense.  
            • There is one way to increase Profit, which is to increase Revenue relative to Expenses in absolute dollar terms so the spread between the two increases.
        • Asset Turnover (Revenue ÷ Average Assets for Period)
        • Leverage, or Equity Multiplier (Average Assets ÷ Average Shareholders’ Equity)
      • … or, alternatively, more granularly refined into five components, multiplied together, which are …
        • Tax Burden (Net Income ÷ Pre-Tax Income)
        • Interest Burden (Pre-Tax Income ÷ Earnings Before Interest and Taxes)
        • Operating Profit Margin (Earnings Before Interest and Taxes ÷ Revenue)
        • Asset Turnover (Revenue ÷ Average Assets for Period)
        • Leverage, or Equity Multiplier (Average Assets ÷ Average Shareholders’ Equity)
      • Book value per share comes from issuance and repurchase of stock, retained earnings, and a handful of other transactions or adjustments, including adjustments for LIFO reserves.
  • The Valuation Multiple Other Investors Are Willing to Pay for Every $1 in Diluted Earnings Per Share
    • This is the result of buyers and sellers bidding with each other on the stock exchange or over-the-counter market, sort of like eBay.  In the long run, it is influenced heavily by the yield on the risk-free rate, which is considered to be the United States Treasury bill, note, or bond with the closest maturity to the cash flows being measured.  Holding all else equal, if the risk-free rate increases, stock prices should be lower to compensate so earnings yields increase (diluted earnings per share divided by the per share price indicating the “coupon” rate one would receive before any dividend taxes assuming no growth and a 100% distribution policy).  Likewise, if the risk-free rate decreases, stock prices should rise so that earnings yields decrease.  Generally, for a stable blue chip stock with reasonable growth prospects, it can be prudent to demand a normalized earnings yield of at least 2x the risk-free rate, adjusting for cyclical influences on per share profits (acknowledging the strange experience with interest rates in recent decades post-Great Recession has muddied the waters).
• The Cash Dividends You Receive
  • Ultimately cash dividends must come from one of a few sources:
    • Profit generated from operations, which is the only sustainable source
    • Asset liquidations, such as if a company sold a division, subsidiary, or other asset and distributed the proceeds.  At some point, you run out of assets so this can be a nice source of cash but is limited by its very nature.
    • Changes in the capitalization structure.  Some companies borrow money when fixed-rate terms are available and interest rates are low, then distribute the borrowed funds, in whole or part, to stockholders as a dividend.  The net effect is a cash dividend, which results in a change in the capitalization structure with a greater proportion of the enterprise value being made up of debt, rather than equity.

Spin-offs are just the breakup of an existing asset.  You are no richer the moment after the spin-off than you were before. Thus, they aren’t a true source of income.  One reason certain spin-offs tend to do better than stocks as a whole, at least after a few years, is because a dedicated management team is able to focus on a more streamlined business and must economically live and die by its results.  In other words, the stakes are lower for Gillette when it’s part of Procter & Gamble than they are when it is a stand-alone publicly traded company with its own stockholders and dividend.

Where it gets tricky is that the figure you are actually using for valuation is not truly diluted EPS. Rather, it should be something called “owner earnings”, which is the amount of money a business owner could extract for redeployment or consumption without changing unit volume or harming the competitiveness of the enterprise.  As I’ve shared on the site many, many years in the past, I make a few modifications for my own personality and the sake of conservatism, but the basic formula is this (see the Additional Notes section for further information):

Reported Net Income
+ Depreciation and Amortization
+/- LIFO Inventory Reserve Adjustments
+/- Accounting Adjustments That Obfuscate Reality
– Additional Working Capital Required to Maintain Current Unit Output and Competitive Position
– Maintenance Capital Expenditures Required to Maintain Current Unit Output and Competitive Position
+/- Adjustment Factor for Overfunded or Underfunded Pension
+/- Adjustment Factor for Other Non-Avoidable Contingent Cash Inflows or Outflows
= Stable Cash Extraction Value for an Owner Opting for a 100% Dividend Policy of Any Earnings Not Required to Maintain Current Competitive Position in the Industry

Then I compare that value, if I could own the entire enterprise, lock, stock, and barrel, to the net capital required to be invested in the business, both equity and total, as a mechanism for determining the quality of the firm’s existing operations, factoring in things like durable consumer brands that would be almost impossible to displace or physical advantages that competitors can’t replicate (e.g., possession of a key oil field, a cement company being mostly local, etc.), or a hidden asset that makes the numbers somewhat inconsequential (e.g., if you were buying a farm on top of a natural gas well that no one knew existed, it would be somewhat foolish to value solely the cash flows from the corn and wheat, without expressly contemplating what you might get from the energy asset that you can monetize) which is the art part of it. I also discount all streams of owner earnings at the same rate rather than attempting to apply varying discount rates to compensate for perceived risk as the former methodology is a pass-fail test. That is, if I am not comfortable enough to feel certain of the owner earnings range, I should confront that fact directly rather than attempt to convince myself it can be mitigated by tweaking the formula.

Knowing Individual Businesses Helps in the Calculation of Owner Earnings

Over years and decades, as you study specific enterprises, it becomes much easier to spot changes not only in their operations, but across industries. For example, an investor who owned a blue chip cash machine like Clorox should know that it is almost entirely a domestic business compared to other large consumer staples (something like 84% of sales are within the United States) and management targets free cash flow in the 11% to 13% of revenue range. Meanwhile, marketing and advertising expense has long run in the 9% to 11% of revenue range broadly and approximately speaking. If the former were to start skyrocketing, but the latter were cut down by a few percentage points, it would be a major red flag that a short-sighted executive team was mortgaging the future to juice profits today. The bill would come due at some point and the headline cash flow numbers wouldn’t be a true indication of sustainable profitability. (This is not happening at the moment with Clorox, I simply used it since nearly everyone in the United States is familiar with one or more of their products.)

Portfolio Construction Is a Different Discipline Constructed from the Building Blocks of Individual Assets

Portfolio construction is itself an entirely different discipline. I’ve said forever that people always ask me about valuation of individual enterprises, when half of my career and time is spent thinking about how those pieces fit together in a given portfolio. Hardly anyone asks about the latter, yet it matters enormously. I think about weightings a great deal. All the time. I’m looking through to the underlying cash flows and viewing the portfolio as one holding company then asking myself what I think it looks like in 5 years, 10 years, or 20+ years. (Sometimes these weightings are influenced by how a company is returning cash. Maybe one day I’ll write about the mechanics of one of the largest trades I ever placed for Kennon-Green & Co. and how it would have differed if the underlying enterprises weren’t paying such large dividends.) The ideal portfolio differs for different people at different times in life, too.

As importantly, knowing the nature of each business, which we discussed a moment ago, helps in constructing a portfolio. Being aware of the forces that drive changes in revenue, or cost structure, can help you manage correlated risk across a collection of businesses. The example I used to give was to think of an oil town in Texas in the 1980s. You might have shares in the local bank, own the local pizza parlor, have some apartment buildings, and collect dividends from shares in the oil major, but if an energy bust happens, a good portion of the ultimate cash flows in that town, which appeared to come from diversified sources, suddenly dries up at once because the thing funding it was wages from the petroleum industry. It was a mirage.

People generally fall into two different categories: top-down investors, who decide on broad areas of the economy first and then narrow their choices, or bottom-up investors, who are looking out across the world for anything intelligent to do within their circles of competence, valuing those assets, and then having their portfolios come to reflect individual opportunities over time. Most value investors, myself included, tend to prefer the latter.

Additional Notes

This is a general academic overview meant to give you the big picture with enough granular detail to understand what is happening under the hood, so to speak. In actual real-world practice, the accounting board has lost its mind since the mid-2010s in ways that require further adjustments to the intrinsic value formula. For example, when I mention diluted EPS or net income, if a company has equity investments on the books that have readily determinable fair values (other than those reported under the equity method or consolidated method), changes in fair value are now run through the income statement. It is absolute nonsense. The old adjustment to the balance sheet for nearly all enterprises was a vastly superior methodology. The change was not modernization, but rather a result of people simply trying to do something to justify their position. It destroyed the utility of reported figures for companies such as Berkshire Hathaway and created heavy incentives to either ignore GAAP (a dangerous precedent) or for managements to pass on otherwise intelligent capital allocation opportunities because of how it may cause their reported numbers to fluctuate, weakening the business over time. In any event, as a result, when calculating intrinsic value, I find it necessary to adjust the above formula further to strip out the contribution from unrealized gains or losses arising from market fluctuations as they tell you nothing of the quality of the underlying cash flows for the actual entity you are purchasing in nearly every case.

Footnotes

* I say “approximated as” because it’s not precisely on point to state diluted EPS is the result of ordinary book value per share × ROE unless earnings, equity, and share-count measures are defined consistently. This arises as a result of timing differences and/or differences between basic and diluted share counts used across calculations. ROE ordinarily uses average equity for the measurement period, while reported diluted EPS uses weighted-average diluted shares. Book value is an end-period measurement figure. This technicality can mean a great deal in situations where, say, a company is buying back a huge percentage of the outstanding shares.