Podcast: What information is used to determine stock price?

A company's financial statements play a critical part in how its share prices fare in the markets. But financial statements aren't the only sources of information markets use to determine the valuation of a company. Professor Herbert Kaufman, vice chair of the finance department at the W. P. Carey School of Business, teaches a class on the essentials of finance and accounting for the W. P. Carey School's Center for Executive and Professional Development. Here, Kaufman explains the kinds of information markets use, and how they use that information, to determine the value of a company's stock.

A company's financial statements play a critical part in how its share prices fare in the markets. But financial statements aren't the only sources of information markets use to determine the valuation of a company. Professor Herbert Kaufman, vice chair of the finance department at the W. P. Carey School of Business, explains the kinds of information markets use, and how they use that information, to determine the value of a company's stock.

Transcript:

Knowledge: A company's financial statements play a critical part in how its share prices fare in the markets. But financial statements aren't the only sources of information markets use to determine the valuation of a company. Professor Herbert Kaufman, vice chair of the Department of Finance at the W. P. Carey School of Business, has this breakdown on what kinds of information the markets use, and how they use that information to determine the value of a company's stock.

Herbert Kaufman: Well, they're always looking at information that the company is required to provide as a public company under SEC rules. So they're always looking at earnings. They're always looking at revenues. They're always looking at the balance sheet.

They're always looking at the income statement and the cash flow statement as well. All this information is extremely important in deciding what the company is worth now. And more importantly since the market is a discounting mechanism, what this implies about the future success or lack thereof of companies going forward.

So, the financial information is really a picture of the situation that the company is currently in, and also a forecast, a validation in a way of what the company says it's going to do going forward, and how the market should then interpret that, and how then — extracting from the overall market direction — how the company should be valued.

Knowledge: What information is most critical?

Kaufman: Information, generally, that the market looks at as critical in evaluating a company are such things, particularly earnings of a company, which is profitability of the company. But also revenues of the company, how successful they are in selling their products whatever the products might be. That kind of financial information is very important.

Knowledge: What are some common financial ratios or relationships to market pricing that the markets construct from financial information?

Kaufman: Probably the most important one — that gets the most attention in any event — is the price/earnings ratio. That is the ratio of the market price for a stock, the individual share price, to the earnings per share. So, that is overall earnings divided by the number of shares outstanding.

That price/earnings ratio is a very important judge for the market of what the market believes the company's future success might be, because as it looks at what the earnings are, it also looks at what the prospects are going forward for the company and the revenues as well.

But the price/earnings ratio, as that price earnings ratio expands, that implies that the price of the company's stock is more valued relative to the earnings that are generated. And that is really a very good sign that the market takes account of in looking at the success of a company. And contrary to that, the more moribund company or the slow-growth company will generally receive a much lower valuation in the market in terms of its price/earnings ratio.

That is, each dollar of earnings will be valued less than it is for a company that is really expanding very rapidly and showing considerable success, success that is expected to continue going forward. There are other ratios as well. One that is going to become more esoteric, another ratio that gets quite a lot of attention is called EBITA.

That stands for earnings before interest, taxes, and amortization. And that ratio is very much found to be useful by potential acquirers. For example, private equity firms use EBITA all the time to evaluate whether a company is going to be successful and, potentially, a successful acquisition going forward.

EBITA is also looked at by analysts to judge the financial strength of a company. And while that's not explicitly a ratio, it is a measure that is grouped with other ratios that are looked at by analysts, and by potential acquirers, and potential stock market investors in terms of valuing a company.

Knowledge: Is company-specific financial information all that the market utilizes in establishing these overall stock market movements?

Kaufman: Oh, no. The company can not be isolated from the way in which both the industry in which it fits as well as the overall market conditions. So, for example, in recent days we've seen that interest rates have risen fairly importantly, fairly materially, higher than they've been now, if we look at the Government or the Treasury Bond market, higher than they've been in several years.

As a result of that the market has felt that impact. It has been impacted by that rise in interest rates because as interest rates rise it costs more to finance all kinds of activities. We know that in terms of the mortgage market, but also in terms of corporate growth and corporate projects going forward as a result of that.

Those factors influence the market valuation of the company. So, it's not isolated from the industry. It's not isolated from the economy. Furthermore, it's not isolated from economic growth overall in the economy. That is the growth in both GDP, which is the overall measure of production in the economy, as well as inflation, which can be a concern. Inflation is a concern of the Federal Reserve.

The Federal Reserve sets monetary policy. Monetary policy impacts interest rates and economic growth. And so, the market is not independent of any of those factors at all. And the valuation for a particular company will be impacted as the market is impacted overall.

However, when you look at a company, and you look at its financial strength in the kind of way that I've suggested, one can argue that those companies that are strongest will probably retain more of their valuation, be less impacted overall, relatively speaking.

In other words, they can decline, but they may not decline as relatively rapidly as other stocks in their industry, or companies in their industry, or companies in the market overall, given their financial strength. And contrary to that, financial weakness will lead to perhaps excessive decline in stock price for a particular company or stock prices for companies that are indeed in a weakened financial condition.

So, while the financial ratios and the financial information does not in itself lead to precise valuation, it leads to valuation in the context of the overall market. And it is very important, therefore, as well as the overall market impact that takes place from changes in economic conditions in interest rates and monetary policy.