5 factors that explain share prices

How do you explain a company’s valuation on the stock market? What moves a share price? What are the reasons for a “fair” valuation, or on the contrary, for an undervaluation?

Technically, many valuation methodologies exist for a company and a stock. Valuation methodologies are mainly based on profit generation (EV/EBITA, P/E…), on future cash flow (DCF), on value creation (EVA-MVA®) and on asset value (P/BV, EV/IC…). As all investors more or less use the same methodologies and do the same calculations, the share prices of listed companies should stabilize around their true intrinsic value (at least in a theoretically perfect and efficient stock market). In reality, that is not always the case. Most of the time, share prices show a significant gap from the intrinsic value of the stock.

To understand these gaps, I believe that there are five factors which explain valuation multiples and share prices.

The company, its business model and the industry

This is of course the main valuation factor on which analysts and fund managers focus. It is the business model of a corporate which determines its capacity to generate future profit and cash flow. This business model has to be put into the context of the industry ; an industry which is growing or not, cyclical or not... A well-established company, in a mature industry in a developed economy will not have the same valuation multiples as an emerging market growth company.

Size and listing

Even if it is a technical factor, the size of the company, its market capitalization, company free float, liquidity and where it is listed, all play a role in the valuation of the stock. A small capitalization, with limited free float, low liquidity and a listing on a minor stock exchange will have little chance to be valued fairly.

The economic environment

The economic environment is the main reason for short and medium term movement of share prices. For many companies, notably “cyclicals”, the economic environment has a major impact on results and futures prospects. Not only does it impact the company’s markets, potential growth and FOREX, but it also impacts interest rates and yields from which valuation calculations are derived. To a large extend, economic indicators and prospects are key reasons for the movement of valuation multiples.

Management and strategy

The CEO and management team play a major role in the development, strategic orientation and the general adaptation of the company to the economic environment. As such, they are critical to the results and therefore, the company’s valuation and multiples. However, for an outsider, it is very difficult to have a clear, objective and quantifiable view on management. It is for this reason that financial analysts rarely give a view on CEOs. That being said, , it does not mean this factor is not taking into account in share prices. Investors meet regularly with management and judge them through their actions (strategy, investments, M&A…).

Stock reputation

Stock reputation that corresponds to the company’s reputation on the stock market is generally not taken into consideration. This is a concept that is typically not formally followed. This is also difficult to reconcile, as it is non-material and not easily quantifiable. Yet, the share’s reputation is essential for listed company valuation. Investment decisions are based on prospects and expectations, but also on the aggregate of past experiences (historic results, share price performance…). A good reputation will be positively valued in the share price because it lowers investment risk, brings trust and gives confidence to the future behavior of the company and its share price. To the contrary, a bad reputation with investors will lead to a valuation discount. In most cases, this is in fact the main reason for under valuation.

Now, for an investor, the question is how these factors change and lead to a share price movement, either up or down.

It is clear that the main factor, which explains most share price movement on a daily basis, is the economic environment. The other factors are much more stable and do not change daily. Unless there is new M&A activity or an important corporate change, the company, its business model and the industry evolve slowly. Similarly, besides a rights issue, the technical factor of size and listing is fixed. The management and strategy can change more frequently, but it remains difficult and risky to invest based upon a potential change of CEO. This leaves stock reputation, which in theory can change more easily and more rapidly than other factors. In reality, a reputation can be destroyed quickly but takes time and work to repair. Companies need to be aware of their stock reputation and actively manage it. Unfortunately, this is rarely the case.