Why do a company's profits affect the price of its stock?

Question

From my vague knowledge of the stock market, it seems that, when a person sells a tenth of a percent of a company's stock, they do not receive a tenth of a percent of the company's net worth, but rather whatever price others are willing to pay for the stock. If the price of a stock is determined only by the demand for the stock, what mechanism links this demand to the company's profits? It seems like people could just choose an arbitrary standard for valuation and cut profits out of the equation. The only thing I could think is that:
1) Higher profits decrease the chance of dissolution, in which case the stock becomes worthless,
2) Profits are an arbitrary standard, but a standard is needed so that is what people go with.

If #1 is the answer, then why this obsession with marginal changes in the profitability of companies (like Coca Cola) that clearly aren't going bankrupt any time soon?

Answer 1

earnings changes , and also earnings per share earnings per share can increase or decrease,some investors look at the price/earnings ratio for the stock and get a comparative with other other stocks in the same industry for comparative.another factor that many investors look at is the growth rate, and the future anticipated growth rate., and that p/e rate divided by the growth rate. another factor for many of us is will future earning be able to cover dividends? will future earning be able to increase dividends while retaining enough earnings for growth and business needs?

Answer 2

Stock price does not directly affect a company's profits. On the other hand, profits impact the stock price. However, if a company has a low stock price and is wanting to raise more capital through offering additional shares, it will obviously not be able to raise as much as if its stock price were high. This can then affect profits because the company has less money to work with for expansion/new projects/etc.

Answer 3

The stock is sold to the highest bidder....there is an asking price listed and a selling price.
Bids are governed by the stocks earnings, outlook for future and overall market sentiment based on several economical indicators.

Most often a stocks price is higher than that percent it represents.
Say 500 million shares out at $10 but the company's assets are worth only $2 billion = $2 per share.

Many companies will operate at a loss but with reasonable expectations to turn to profit and maintain share value.

Answer 4

Theoretically the "right" price to pay for any investment is the present value of the future payments you will receive from the investment. For an investment like a zero coupon bond that is fairly simple. If I promise to pay you $105 one year from now and you use a 5% discount rate then you would pay me $100 now. It gets a little harder with an investment that pays interest or dividends periodically but basically you calculate the present value of each payment and add them up to get the present value of the investment.

Where it gets tricky is with an investment like a share of stock because the primary future payment will be when you sell the share of stock. Unless you have a really good crystal ball or Ouija board you have to rely on the current state of the corporation, its historical performance, and its prospects for future performance (taking into account the economy, geopolitical events, demographic changes, etc.) to guess what it will be worth in the future.

Much of the day-to-day fluctuation in price is due to the new information made available to the public. Some news is indirect (trouble in the Middle East probably higher short-term profits for oli companies, Gateway sold more computers last quarter so Dell probably did too) but the best information is direct information about the company in question and the most important news is about profits.

But here's the real catch. What's really important is not past profits, but the probability of future profits.

Here's where the theory of pricing investments goes all to heck. During the 1990s stocks in general but especially tech stocks and "dot com" companies' stock prices got totally disconnected from their performance. Companies with no legitimate prospect of ever making a profit were selling for thousands of times the company's worth. The is the "bigger fool" theory (i.e. I don't really believe this stock is worth $100 per share but I believe somebody else will be dumb enough to pay $110 for it soon so I'll pay $100 now). The trick is not to be the last fool, the one who owns it when it becomes widely accepted that the party is over.

Another thing that complicates the pricing is that different groups are looking at different timeframes. Day traders may be betting on price changes in the next few hours while pension funds may be betting on price changes over several decades.

The price at any point in time is determined by how many buyers are willing to buy how many shares at what price and how many sellers are willing to sell how many shares at what price.

Answer 5

The market works a lot on expectations. They may have great profits, but the market may think those times of huge profits are over. Plus it's not just profit that determine a stock price. Risk has a lot to do with it. Plus, a stock can go down just because others are going down.

Answer 6

There is no standard of determining stock prices.

Various industries have different levels of P/E (price to earnings)ratios for stocks, and that's where the confusion is.

High growth rate stocks tend to also have high P/E ratios given their perceived prospects for future profits.

The demand determines the price of a stock, and demand wavers according to undetermined variables such as mood, time of year, bullish or bearish sentiment.

You must understand that a stock price is the collective opinion of what a company is worth at a particular point in time, determined by the mass of people buying and selling it.

So, stock prices fluctuate at whim.

Answer 7

The stock price is based on what people believe the company is worth. In the long run more profit = more valuable company.