Foctors That Move Stock Prices

These forces fall into three categories: fundamental factors, technical factors and market sentiment.

Fundamental Factors

In an efficient market, stock prices would be determined primarily by fundamentals, which, at the basic level, refer to a combination of two things:
1) An earnings base (earings per share (EPS), for example) and
2) a valuation multiple (a P/E ratio, for example).

An owner of a common stock has a claim on earnings, and earnings per share (EPS) is the owner's return on his or her investment. When you buy a stock, you are purchasing a proportional share of an entire future stream of earnings. That's the reason for the valuation multiple: it is the price you are willing to pay for the future stream of earnings.

Part of these earnings may be distributed as dividends, while the remainder will be retained by the company (on your behalf) for reinvestment. We can think of the future earnings stream as a function of both the current level of earnings and the expected growth in this earnings base.

About the Valuation Multiple

The valuation multiple expresses expectations about the future. As we already explained, it is fundamentally based on the discounted present value of the future earnings stream. Therefore, the two key factors here are 1) the expected growth in the earnings base, and
2) the discount rate, which is used to calculate the present value of the future stream of earnings. A higher growth rate will earn the stock a higher multiple, but a higher discount rate will earn a lower multiple.

What determines the discount rate? First, it is a function of perceived risk. A riskier stock earns a higher discount rate, which in turn earns a lower multiple. Second, it is a function of inflation (or interest rates, arguably). Higher inflation earns a higher discount rate, which earns a lower multiple (meaning the future earnings are worth less in inflationary environments).

In summary, the key fundamental factors are:

• The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends per share)

• The expected growth in the earnings base

• The discount rate, which is itself a function of inflation

• The perceived risk of the stock.

Technical Factors

Technical factors are the mix of external conditions that alter the supply of and demand for a company's stock. Some of these indirectly affect fundamentals. (For example, economic growth indirectly contributes to earnings growth.) Technical factors include the following:

• Inflation - We mentioned inflation as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies. (To learn more, read All About Inflation.)

• Economic Strength of Market and Peers - Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements - as opposed to a company's individual performance - determines a majority of a stock's movement. (There has been research cited that suggests the economic/market factors account for 90%!) For example, a suddenly negative outlook for one retail stock often hurts other retail stocks as "guilt by association" drags down demand for the whole sector.

• Substitutes - Companies compete for investment dollars with other asset classes on a global stage. These include corporate bonds, government bonds, commodities, real estate and foreign equities. The relation between demand for U.S. equities and their substitutes is hard to figure, but it plays an important role.

• Incidental Transactions - Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often prescheduled or driven by portfolio objectives. Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official "votes cast" for or against the stock, they do impact supply and demand and therefore can move the price.

• Demographics - Some important research has been done about the demographics of investors. Much of it concerns these two dynamics: 1) middle-aged investors, who are peak earners that tend to invest in the stock market, and 2) older investors who tend to pull out of the market in order to meet the demands of retirement. The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples. (For more on this, see Demographic Trends And The Implications For Investment.)

• Trends - Often a stock simply moves according to a short-term trend. On the one hand, a stock that is moving up can gather momentum, as "success breeds success" and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean. Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are "trendy" does not help us predict the future. (Note: trends could also be classified under market sentiment.) (For more insight, check out Short-, Intermediate- and Long-Term Trends.)

• Liquidity - Liquidity is an important and sometimes under-appreciated factor. It refers to how much investor interest and attention a specific stock has. Wal-Mart's stock is highly liquid and therefore highly responsive to material news; the average small-cap company is less so. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community). Large-cap stocks have high liquidity: they are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent "liquidity discount" because they simply are not on investors' radar screens. (To learn more, read Diving In To Financial Liquidity.)



Market Sentiment

Market sentiment refers to the psychology of market participants, individually and collectively. This is perhaps the most vexing category because we know it matters critically, but we are only beginning to understand it. Market sentiment is often subjective, biased and obstinate. For example, you can make a solid judgment about a stock's future growth prospects, and the future may even confirm your projections, but in the meantime the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.
Market sentiment is being explored by the relatively new field of behavioral finance. It starts with the assumption that markets are apparently not efficient much of the time, and this inefficiency can be explained by psychology and other social sciences.  Many of the ideas in behavioral finance confirm observable suspicions: that investors tend to overemphasize data that come easily to mind; that many investors react with greater pain to losses than with pleasure to equivalent gains; and that investors tend to persist in a mistake.

Some investors claim to be able to capitalize on the theory of behavioral finance. For the majority, however, the field is new enough to serve as the "catch-all" category, where everything we cannot explain is deposited.



Summary

Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe strongly in fundamentals can reconcile themselves to technical forces with the following popular argument: technical factors and market sentiment often overwhelm the short run, but fundamentals will set the stock price in the long-run. In the meantime, we can expect more exciting developments in the area of behavioral finance since traditional financial theories cannot seem to explain everything that happens in the market.

Cash Flow

Cash (Flow) Really Is King


One of the most important lessons entrepreneurs have to learn, often painfully, is that cash really is king.

 Employees can't wait on paychecks until your customers pay.
Your landlord doesn't care that you're talking to investors and will have the money in a couple of months. Suppliers may not be willing to extend your credit any further and you may not be able to purchase the goods you need in order to deliver to your customer and receive payment.

More businesses fail for lack of cash flow than for lack of profit. Why is this? Two main reasons:

1. Business owners are often unrealistic in predicting their cash flow. They tend to overestimate income and underestimate expenses.
2. Business owners fail to anticipate a cash shortage and run out of money, forcing them to suspend or cease operations, even though they have active customers.

Let's start by differentiating between profitability and cash flow:

Profit is the difference between income and expenses. Income is calculated at the time the sale is booked, rather than when full payment is received. Likewise, expenses are calculated at the time the purchase is made, rather than when you pay the bill.

Cash flow is the difference between inflows (actual incoming cash) and outflows (actual outgoing cash). Income is not counted until payment is received and expenses are not calculated until payment is made. Cash flow also includes infusions of working capital from investors or debt financing.

Cash flow is often calculated on a monthly basis, since most billing cycles are monthly. Most suppliers will typically allow somewhere close to thirty days to pay. However, in a cash-intensive business with a lot of inventory turnover, such as a restaurant or convenience store, it may be necessary to calculate on a weekly or even daily basis.


CASH FLOW AND PE RATIO

Cash Flow is Better than P/E
Cash flow ratios are a better measurement of a stock’s value than price earnings ratio (P/E).
\How much cash a company can generate is one of the more important measures of its health. Yet, you will hear more about P/E than almost any other metric on valuation, but it does not give you an accurate picture of a company’s ability to generate cash.

P/E represents the ratio of the stock’s price to its earnings per share (EPS). It is an important metric, if for no other reason because so many people think it is. When a company’s P/E is very high or low, it gets top billing on the news.

Overlooked by many are the equally important metrics that examine a company’s price relative to its cash position.

Importance of Cash

The reality is that without cash, a company won’t last long. That may seem obviously simple, however there is a long list of companies that failed because cash was in too short supply.

So, how do you use cash flow ratios to see if a company is under or over-valued, which is the same purpose of P/E? Two primary measurements shed light on a company’s valuation.

Price to Cash Flow

The price to cash flow is determined by dividing the stock’s price by cash flow per share. The reason many prefer this measurement is the use of cash flow instead of net income (found in computing EPS).

Cash flow is a company’s net income with the depreciation and amortization charges added back in. These charges, which reduce net income, do not represent outlays of cash so they artificially reduce the company’s reported cash.

Since these expenses don’t involve actual cash, the company has more cash than the net income figure indicates.

Free Cash Flow

Free cash flow is a refinement of cash flow that goes a step farther and adds one-time expenses capital expenses, dividend payments, and other non-occurring charges back to cash flow. The result is how much cash the company generated in the trailing twelve months.

You divide the current price by the free cash flow per share and the result describes the value the market places on the company’s ability to generate cash.

What they Mean

Like the P/E, both of these cash flow ratios suggest where the market values the company. Lower numbers relative to its industry and sector, suggests the market has undervalued the stock.

Higher numbers than its industry and sector may mean the market has overvalued the stock.


Cash Flow Statement
A cash flow statement, along with the balance sheet and income statement, are the three most common financial statements used to gauge a company’s performance and overall health. The same accounting data is used in preparing all three statements, but each takes a company’s pulse in a different area.


The cash flow statement discloses how a company raised money and how it spent those funds during a given period. It is also an analytical tool, measuring an enterprise’s ability to cover its expenses in the near term. Generally speaking, if a company is consistently bringing in more cash than it spends, that company is considered to be of good value.

A cash flow statement is divided into three parts: operations, investing and financing.
Cash from operations: This is cash that was generated over the year from the company’s core business transactions. Note how the statement starts with net earnings and works backward, adding in depreciation and subtracting out inventory and accounts receivable. In simple terms, this is earnings before interest and taxes (EBIT) plus depreciation minus taxes.

Interpretation:This may serve as a better indicator than earnings, since noncash earnings can’t be used to pay off bills.

Cash from investing: Some businesses will invest outside their core operations or acquire new companies to expand their reach.

Interpretation: This portion of the cash flow statement accounts for cash used to make new investments, as well as proceeds gained from previous investments.

Cash from financing: This last section refers to the movement of cash from financing activities. Two common financing activities are taking on a loan or issuing stock to new investors. Dividends to current investors also fit in here.

Basic rules of cash flow

Cash flow is the lifeblood of all businesses. Learn the Cash Flow   Rules to free yourself from money worries. Use the basic rules of to help you take control of your cash flow so you can create the business you have always dreamed of.


1. Never Run Out of Cash. Running out of cash is the definition of failure in business. Make the commitment to do what it takes so it doesn't happen to you.

2. Cash Is King. It's important to recognize that the basics of cash flow  are what keeps your business alive. Manage it with the care and attention it deserves. It's very unforgiving if you don't. Remember, cash is king, because no cash means no business.

3. Know the Cash Balance Now. What is your cash balance right now? It's absolutely critical that you know exactly what your cash balance is. Even the most experienced person will fail if they are making business decisions using inaccurate or incomplete cash balances. This is fundamental cash flow  . That's the reason why business failures are not limited to amateurs or people new to the business world.

4. Do Today's Work Today. The key to keeping an accurate cash balance in your accounting system is to do today's work today. When you do this, you will have the numbers you need - when you need them.

5. Do the Work or Get Someone Else. Here is a simple rule to follow to make sure you have an accurate cash balance on your books. You do the work or have someone else do it.

6. Don't Manage From the Bank Balance. The bank balance and the cash balance are two different forms of cash. Rarely will the two ever be the same. Don't make the mistake of confusing them.

It's futile and frustrating to attempt to manage your cash flow using the bank balance. It's a prescription for failure. You reconcile your bank balance. You don't manage from it.

7. Know Your Six Months Cash Balance. What do you expect your cash balance to be six months from now? This one question will transform the way you manage your business and help you pass cash flow .

This question really gets to the heart of whether you are managing your business or whether your business is managing you.

8. Cash Flow Problems Don't Just Happen. You would be amazed at the number of small businesses that fail because the owner did not see a cash flow problem in time to do something about it. The key is to always be able to answer the question - what do I expect my cash balance to be six months from now?

9. Have Cash Flow Projections. Cash flow projections are the key to making wise and profitable business decisions. They give you the answer to the all-important question from Rule # 7. It's impossible to run your business properly without them.

10. Take Care of Customers. Eliminate your cash flow worries so you are free to do what you do best-taking care of clients and making more money. Use these cash flow  rules to free yourself from cash flow worries. That way you can focus all your time and talents where you can make the most difference in your business.