Factors Determining Stock Price

Factors Determining Stock Price: Literature hypothesizes that the fluctuations in earnings are much more pronounced than the fluctuations in dividends. A downturn in earnings is not followed by a downturn in dividends unless the downturn in earnings persists for a long period. As result management knows that the market reacts negatively to dividend downturns, hence they are supposed to try to avoid this decline. By paying dividends in years with negative earnings, management signals to the investors that the decline in earnings is temporary, and that positive earnings are expected to prevail in the future.

Factors Determining Stock Price

Investors may or may not prefer dividends to capital gains and at the same time prefer predictable to unpredictable dividends. However, there are many factors influencing a company’s dividend policy in practice. But all the factors are not identical for every company. The company management may adopt such a policy in order that it may retain control of the company’s operations. A company’s dividend policy is, therefore, influenced by its investment and financing decisions and by some influencing factors as well.

To gain an understanding of what determines the prices of a stock, I like to consider in this section of the chapter, what determines the price of an individual stock. The prices of stock will be determined by trading among individuals. Even if these stocks themselves are not directly traded, we can merely infer their prices in a competitive market from the prices of the stocks that are traded. To understand the stock market accurately, an investor will find the following determinants that affect the prices of the stocks. It is logical to expect a relationship between corporate profits and securities prices. So, expected earnings and interest rates are the ultimate determinants of securities prices.

The transfer of capital between markets would raise the interest rates that affect the securities prices in two ways:

1. The high rate of interest lessens the firm’s profits
2. Interest rates affect economic activities that affect corporate profits.

Interest rates obviously affect the securities prices because of their effects on profits. They have also an effect due to the competition in the stocks and bond markets. The higher rate of interest causes the investors to sell stocks and transfer funds to the bond market. Thus, a higher rate of interest depresses securities prices. Inflationary pressures are strongest during the business boom, and that also exerts upward pressure on rates. Slack business reduces the demand for credit; the rate of inflation falls and the result is a drop in interest rates.

However, this section of the article will strive to explain the factors determining the firm’s dividend and the stock price as well. Factors Determining Stock Price and firm’s dividend as well

The expectation of future earning:

The market price of a share equates the present value of expected future returns. The shareholders’ expectation of dividends is generally guided by the future earnings of the company. It may be assumed that shareholders prefer dividends if companies use retained earnings inefficiently although transaction costs and taxation considerations generally favor retentions rather than dividend payments.

The pattern of past dividends:

While making the dividend decisions of a year, firms give emphasis on the last year’s dividend.

Availability of cash:

Cash flow is the most important determinant of dividends. Cash dividends can only be paid with cash. Thus, a shortage of cash in the bank may restrict dividend payments.

Corporate earnings:

Corporate earnings are considered as the primary determinant of dividends as they provide the cash flow necessary for the payment of dividends. If management increases the proportion of earnings per share paid out as dividends, shareholders would become wealthier, suggesting that dividend decision is a very important one. Dividends payments usually may not exceed retained earnings.

Matter increases stock prices:

An increase in payout ratio provides signals to investors a potential growth in the future that increases the value of the firm. A firm would suffer the impact of negative signals when it decreases dividend payout. Information on changes in earnings with existing dividend rates is also the most important determinant of the firm’s dividend policy.

Interest rates:

Existing interest rates affect the profits of the company. Investors always compare the existing interest rate with dividend income. Comparatively, a high rate of interest influences the investors to invest in fixed income securities like bonds etc. rather than stocks. Therefore, a high rate of interest depresses securities prices.

Transactions costs:

Transaction costs incurred when the company pays dividends and issue new shares to finance its investment opportunities. This thing can be considered while making dividend decisions. On the other hand, retentions do not incur transaction costs. Thus the presence of issuing costs suggests that shareholders should favor retention rather than dividends. But a shareholder being forced to sell shares for income through a lack of dividend must incur selling costs.

Business expansion:

The firm’s investment needs and financing opportunities can influence its dividend policy. Firms having profitable investment opportunities may prefer to retain a large fraction of their earnings that causes the payout to be relatively low. According to the theme of financial analysts, growth companies with abundant investment opportunities should reinvest their earnings hampering dividend payments. Financial analysts pointed out a number of factors like shareholders’ expectation, the past pattern of dividend payments, cash needs for the company, current earnings of the company, expectation of future earnings, tax consideration, legal constraints, and owners’ and capital market consideration affecting a form’s dividend policy.

Managers have access to the information about the expected cash flows of the firm not possessed by outsiders and thus, changes in dividend payout may provide signals about the future cash flows of the firm that can not be communicated credibly by other means. Empirical studies indicate that dividend changes convey some unanticipated information to the market. Another theoretical issue concerns the extent to which investors with different dividend preferences are the clientele effect. Possible reasons for the formation of clienteles are different perceptions of the relative riskiness of dividends and retained earnings and different investor tax brackets. Being insiders sometimes the financial managers and analysts have access to the information about expected cash flows of the firm not possessed by the outsiders. On the other hand, changes in dividend payout providing signals about the firm’s future cash flows cannot be communicated by other means.

However, it may be noted here that the apparently significant industry effect may exist from the fact that variables are often similar within a given industry. These similarities are the fundamental reasons why firms in the same industry have similar dividend payouts.

Valuation Model

According to the valuation model, dividends, required a rate of returns, earnings per share, price earning ratio ultimately determine the prices of the stocks.

Read More: Basic Valuation Model.

Although a firm’s industry does not help to explain its dividend payout ratio, economic analysis can innovate some effect of industry on the dividend policy and the value of the stock as well. However, it may be noted here that the apparently significant industry effect may exist from the fact that variables are often similar within a given industry. These similarities are the fundamental reasons why firms in the same industry have similar dividend payouts.

According to the valuation model, dividends, required the rate of returns, earnings per share, price earning ratio ultimately determine the prices of the stocks. Furthermore, a complete model of economic variables is desired to understand the stock market more accurately.

A classical model to determine the stock prices identifying exogenous and endogenous variables determining the stock of a company can be shown by the following flow diagram exhibited in the following  Figure.

The above Figure shows that the potential output of the economy being the non-policy variable along with three active policy variables- fiscal policy, monetary policy, and corporate tax rate ultimately affect the prices of the stocks.

Two independent variables like government spending (fiscal policy) and money supply (monetary policy) affect the stock prices in two way:

i) by affecting total spending that along with corporate tax rate affects corporate earnings which are positively related to changes in stock prices,

ii) by affecting total spending which along with the potential output and past changes in prices determine current changes in prices which ultimately determine current changes in real output. Output and changes in prices cause inflation and real growth influencing the current interest rate.

Interest rates possess a negative influence on stock prices. Potential output, government spending, money supply, and corporate tax rate cause the changes in total spending, price level and real money which ultimately affect corporate earnings and interest rates. Interest rate is negatively related to price earning ratio and, in turn, corporate earnings and price earning ratio determine the stock prices.

The ultimate determinants of stock prices are present and expected earnings of the corporation and prevailing interest rates. There exists a strong positive relationship between corporate net earnings and stock prices. The expected value of the stock and the market as well should be a function of the expected streams of benefits to be received and the investors’ required rate of return. Investors will expect corporate net earnings and dividends to rise and as a result stock prices will tend to rise if the economy is prospering.

Factors Determining Stock Price

The Relationship Between the Stock Price and its determinants

However, the relationship between the stock price and its determinants are summarized below:

Factors Determining Stock Price.