Fundamental reasons for the stock price change

Question

Let us start from the old times, where markets were less liquid. Suppose I hold some stocks of the company XYZ and I want to sell them. Why shall I expect that their price can rise in the next quarter given that company showed good in the current quarter and is likely to do well in the future? I could name at least three reasons for that:

1. The dividends on these stocks will be higher

2. If I own enough stocks, the buyer of them can play a role in managing the company

3. The buyer of stocks will expect that the price will grow even further and wants to speculate on the stocks by selling them for a higher price, say, in a year.

The latter reason is a bit cyclic though: if it would be the only reason to buy a stock - then the only thing determining the price direction would be the expectation of market participants - even not about the company itself, but about the price direction. As a result, in such situation I would not see any connection between the fact how the company does, and how the stock price changes.

At the current moment, there are a lot of companies that do not pay any dividends on their stocks, and there are a lot of investors that buy/sell stocks of these companies in amounts much less to talk about affecting the company's management. I wonder thus, whether for such companies there is no any connection between how company does, and how the stock price moves. Perhaps, that could be illustrated by a dotcom situation 15 years ago. By a fundamental reason for a price change I mean something that does not depend only on the expectation of the market about the stock's price, and is related to the company itself.

Edited: I've just found a very nice and useful discussion here which almost answers my question. At the same time, I would be happy if a more quant-oriented community says its word.

Answer 1

Its a bit of a broad and almost philosophical question to be honest. Just two things that pop in mind are (A) the money supply (& possible inflation) in combination with interest rates - this will drive the major money allocation in the world. As you see now with S&P at record highs on the back of massive quantitative easing and low interest rates. Money has to go somewhere (for fund managers and the likes) to bring returns. (B) mergers and acquisitions - major driver for some hedge fund plays on relative valuation of the stock prices of both companies.

But then again, just two things (of many more) that pop up...

Answer 2

In general, from a fundamental analysis viewpoint, a good buy would be a stock, whose price is lower than its fundamental value. In Rational Expectations theory, all future payments are already correctly priced into the stock price, so (1) an assumed rise of dividends, which you mention, would be already reflected by the stock price. If not so, you could arbitrage on that mispricing. (2) makes no sense, in my opinion, since, in general, the manager of the company has the best information set, so a participation of the stock buyer in the decision process would not necessarily lead to an increased value. (3) is most likely the motivation of a fundamentalist, but only if he thinks that he knows better than others. Anything else would be technical analysis, i.e. the assumption that future price patterns can be explained by the former price process. This is in contradiction with FA though, because, as explained earlier, that information would have already been processed. Look up "Efficient Market Hypothesis" on this topic. So, I think, fundamental reasons for a price change can only be explained by a current under-(over-)valuation of the stock, a trade of fundamentalists on this mispricing and a price correction in the future.

Answer 3

Be careful. I can think of three other reasons off the top of my head potentially to buy a stock in a company with zero dividend payouts!

1) a competitor might buy them out for access to their franchise and cashflows.

2) the company might buy back their stock, reducing the share count. By definition, the investors who sell are the "weakest hands" in the investor base. They get paid out at current market prices to leave; and the incumbents who have more confidence in the company's prospects have the option to call time if they lose confidence. Effectively, the company is re-investing in itself, locking in a return of whatever the firm's (sustainable) free-cashflow yield is. Seen thus, the company is effectively a tantine, where the "survivors" accumulate while the proverbial "fatalities" get paid out on exit.

3) if (and it's a big if) the incremental return on capital from new projects is higher than the dividend yield, then it makes sense to capex revenues rather than pay them out. The implicit reasonable quid quo pro is that when the business matures, it should start to behave as a "cash cow" and hit the dividend and buyback pumps hard then.

Plus there might be a whole host of fundamental reasons to buy or sell a stock even if the operating performance of the company doesn't change in any way whatsoever.

If you're discounting dividends, then the discount rate as well as the dividends can change. Let's say I could predict with absolute certainty that a company trading at 100 would pay out a dividend of 3 growing by 5% in perpetuity. I am going to earn an 8% return sitting and holding it. If for some reason unrelated to the company I might decide that 7% or 9% was the appropriate/required return, the same operating fundamentals would be worth 75 or 150 instead. I'd become a buyer or seller at 100.

Maybe the company's bonds start to look incredibly cheap, giving me the lion's share of the reward for a fraction of the risk. I have to sell the stocks I hold to buy the bonds. Suppose a new company comes along in a different sector with the same payout profile but a cheaper price. Shouldn't I switch horses? Suppose the company's prospects remain completely unchanged; but those of its competitors improves. I want to buy more of the others; but to do that, I am going to trim my current holdings in the industry.

The point here is that the choice to own any company's stock reflects a relative choice between its operating fundamentals and a range of potential alternatives. These exist not only within the equity market, but across financial markets more broadly. The company's ability to generate profitable revenues, and then pay these out to investors, is but one of the relevant set of fundamentals to consider.

None of the arguments above are "speculative" in the sense of the "Keynesian Beauty Contest", ie anyone expecting that everyone else will get more or less bullish in the future, moving the price. They're not even speculative in the sense of me thinking that the company's prospects will improve or deteriorate! I suppose I'm arguing that a positive absolute view about a company's prospects is a necessary but insufficient precondition for the relative decision to buy or continue to hold its stock.

Answer 4

The fundamental reason for a stock to go up in value is that it produces income, and as long as that 100% of net income is not paid out as dividend or diluted by new stock, then that is the income held by company on behalf of the investors.

Say you go to buy a business tomorrow, the value of that business will generally be it's predictable cashflow plus some terminal value -- all discounted to today, plus any excess capital not necessary to operate the business (hence excess cash or investments the business hold that is excess equity or assets which haven't been distributed).

If all the future parameters stay the same then 1-year from the date of purchase the income/cash generated by the company, post tax, is the additional value of the stock + it's discounted cashflow. That is why the stock from year 1 to year 2 has greater value.

If a company is losing money every year, such as those in growth/startup phase or that are losing their revenue to competitors or otherwise, where they keep borrowing or raising money, technically they have diluted or lost value and shouldn't be valued higher next year -- but the reason growth stocks continue to be valued higher is that they are projected to turn profit in a future out year and plus have a terminal value that is positive -- all that discounted back is to be valued more in than the negative loss's each year. This the basis of growth stocks which continue to have a loss in the business.

Hope the above helped.