Before you start investing in stocks, you should have a little know-how about how a stock is valued. Even though huge organizations solely work on complex valuations and analysis of companies and their stock values, new investors should have a broad idea of what influences the stock price. To understand this general idea in a better way, let’s break it down into three main categories – Company Financials, Growth Trajectory and Macro Variables
Company Financial statements are the reports that tell us about its revenues, costs, gross profit, net profit, and other complex factors that go into its finances. (Don’t worry, we will cover these in detail in our coming videos and blogs.) The vital thing to note here is that while these reports tell us about the company’s past trends and standings, they also present its future goals and directions. And it is mainly the future that an investor should be concerned with. The stock price, when valued, is projected keeping in mind the future of the company and the overall market.
Every public listed company is required to release its financial statements quarterly (after every four months). These financials enable the investors to do a cash flow analysis that helps understand how the company is managing its cash flows.
Since the future is what we are mainly concerned with, the company’s growth trajectory becomes one of the key factors that affect its stock price. How well the company is performing in the current scenario and how well it will grow in the future determine its stocks’ value.
To show how important growth trajectory is, let’s take the example of a tissue paper company. During COVID, the tissue paper company gave an excellent performance, but as COVID began to subside, people reduced the purchase of tissue papers. Even though the company finances showed a boost, the stock price dropped significantly because investors were not expecting a high cash flow and projected a decreasing growing curve.
Macro variables refer to those factors that affect the overall market and national economy. They usually comprise wide phenomena such as inflation, GDP, price levels, government’s economic policies, and risk-free rates. While they are not directly linked to the stock value, they have an indirect and deep connection with the overall stock market. Without getting into complex calculations, let’s take the example of risk-free rates. A risk-free rate means the guaranteed return of an investment with no risk of loss. They are determined by the governmental bodies in their policies when they issue interest rates for Treasury Bills and Government Bonds (government securities). If the risk-free rate goes up, the risk attached with stocks also goes up. ‘How?’ you might ask. Basically, if government security provides a guaranteed higher return, investors would require an even higher return for taking on extra risk by investing in stocks instead of Treasury notes. And eventually, a high required return would mean a drop in stock prices. If nothing else changes, the price has to be lowered to have a high return.
All in all, the value of a stock is determined by multiple, complex factors. However, the investor should know about the three prominent influencers – Company financials, growth trajectory, and macro variables. All three of them tell the investor how much profit the stock would return in the coming future, and based on that, the stock’s value is determined.