Literally millions of man-hours have gone into the study of stock price in the real world, and many correlations between factors as varied as “fundamentals” like profits and “psychologicals” like news stories have been identified.
Capstone®, however, is an educational tool. It takes a simple approach to stock price, highlighting the basic drivers. In Capstone®, stock price is a function of:
There are only four ways to affect book value:
Generally, book value climbs if management keeps the profits as retained earnings and does not pay dividends. Historically, in the days when a balance sheet reflected the wealth producing assets like land and factories, book value was a fair estimate for the value of stock. In today’s world, off balance sheet assets like customer lists, brand equity, or access to markets swamp book value.
Earnings Per Share
Earnings per share (EPS) looks at the wealth that is being created on each share of stock. It is a somewhat useful predictor of future earnings. The EPS will either wind up in the stockholders hands directly as a dividend, or it will be retained and used to enhance the wealth creation capabilities of the company. Therefore, one school of thought says that a stock price should reflect the present value of a future EPS stream, and if we can somehow predict that stream we can predict the stock price.
Dividends
Dividends are usually a portion of the earnings per share. Therefore, let us look at the limits first, a dividend of zero and a dividend greater than the EPS.
When management doesn’t pay a dividend, it is saying, “Let’s keep the profits. We will invest it at a high return, and we will leverage it to against additional new debt. The company will get bigger and better at producing future earnings.” This makes sense to investors, but it is not quite the same as having cold hard cash placed in an investor’s palm. If management is correct, EPS will go up in the future, and the stock price will rise. However, if dividends fall, stockholders must consider the possibility that management will do worse with the money than the stockholder, and stock price will fall.
Above the EPS, management is extracting excess equity and giving it stockholders. This may be appropriate, but it cannot be sustained. Eventually all of the equity would be paid out. Therefore, a stockholder does not reward the company with a higher stock price.
A good dividend policy might look like this:
In short, dividends should represent the “excess” profits that are not required for growth in working capital and new plant. Consider the alternative. If you keep the profits and do not put them to use, your financial structure must change. Idle assets, especially cash, will accumulate. You will feel pressure to do something with the cash. Teams often pay down debt, which further affects the financial structure. Instead of making financial policy, they observe it.
Returning to stock price, a dividend can be compared to the interest payment on a bond. Given the payment and the interest rate, we can easily determine the principal. Since dividends can be volatile, Capstone® stockholders look at last year’s dividend (up to last year’s EPS) and this year’s dividend (also up to this year’s EPS) and calculate an average dividend.
Emergency Loan Penalties
Emergency loans are issued to companies that run out of cash during the year. Typically, these companies produce too much inventory or allow purchases of capacity and automation to go unfunded. Emergency loans are a shock to stockholders. To cover the cash shortfall, management was forced to seek funding with above-market interest rates. Clearly this will affect the stockholder’s valuation of the stock. Capstone® addresses this as follows:
Stock Price Implications
The implications stock price has on other performance measures include:
At a big picture level, emphasizing stock price has much the same effect as ROE. Managers are reluctant to issue stock and accumulate earnings, but feel pressured to grow the company. In the long run, emphasizing stock price can stunt a company because of limits placed on reinvestment.