My body weight varies daily by small percentages, but over time the change can be substantial. Because, as a human, I am fixated on the reason why something happened, I blame or credit the result on nutrition, exercise, and various other conditions. The only thing I know for certain is that my body weight has changed.
Stock prices have a similar condition, although the percentage change can be dramatic even over a short time period. We blame or credit the change on earnings, economics, politics, weather, or a host of other culprits. Similar to the scales, the only thing we know for certain is that the price per share changed.
When a share price changes, the typical explanation is multiple expansion or contraction or an earnings change. This can sound overly complex, but it is important to grasp.
Multiple expansion refers to the comparison of the price of one share of stock to the earnings of one share. This computation will provide the PE (price-earnings) ratio. If a share price is $100 and the earnings per share are $10, the ratio is 10. If the same company’s share price increased to $150 and the earnings stayed the same at $10 per share, the ratio would be 15.
The higher the ratio or multiple, the more associated risk that the price could either decline or increase at a slower rate. Companies that are growth oriented tend to have higher multiples than companies that are value-oriented. Market pundits often refer to the multiple of the S&P 500 to indicate whether the market is over or undervalued relative to historical multiples.
The earnings associated with a stock come directly from how the underlying company is performing and how it is managing the business. A company with massive revenue that invests all its resources in more technology, people or any other investment will have less earnings and a higher PE ratio. A company that strives to pay out dividends and invest less in the company will have more profit per share and thus a lower multiple.
Historically, about 70% of an individual stock price is considered to be obtained systematically. That fancy word means that the result was more influenced by the entire market than the individual company. The remaining 30% of the stock’s performance is based on the actual performance of the individual company and is referred to as unsystematic. Congratulations! You have now completed the course on investing multiples.
The price of a stock changes because people paid more or less for the stock. The reasons can be complex or simple. The multiple may or may not be a part of the reason to buy or sell. My experience questions the 70/30 split we were taught as academics, but there is a splinter of truth even if the percentages are wrong. Birds of a feather do flock together, and stock multiples – what people are willing to pay – do rise and fall together.
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