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Morningstar.com's Interactive Classroom

Course 209
Why Does a Stock's Price Rise or Fall?

Introduction

Watching the ups and downs of stock prices can be enough to make you seasick. If you own stocks, you've undoubtedly followed their prices with a feeling of either satisfaction or disappointment, depending on how your investments have done. Short-term swings can be bewildering, and sometimes it seems as though stock prices follow a logic all their own. Even so, it is possible to break down stock performance in ways that help distinguish solid growth from inflated expectations.

Case Study in Rising Prices: Wal-Mart

A stock's price is determined by its fundamentals (how the company has actually performed) combined with its valuation (how much the market is willing to pay for that performance and the promise of future growth). Similarly, when a stock's price goes up, that rise comes from either (1) growth in the underlying business or (2) an increase in the stock's valuation, as the market becomes more optimistic about the company's future. As an illustration of these two drivers of stock performance, consider the history of Wal-Mart WMT. In the 1970s and 1980s, Wal-Mart was the quintessential growth stock. It was profitable, with returns on equity consistently above 20%. Year after year, its revenue and earnings grew by more than 25%, often by more than 30%, as it opened new stores all over the country. As a result of this consistent growth, the annualized return of Wal-Mart's stock from 1970 to 1990 was about 35%. That's an impressive figure, but most of this return came from solid growth in revenue and earnings; Wal-Mart's valuations increased only modestly during this time. In the early 1990s, this growth began to slow as the retailing giant started running out of places to expand in the United States. The number of new Wal-Mart stores barely inched up in 1994, after routinely increasing by 10% annually, and the following year the company's revenue growth dropped to less than 20% for the first time ever. Suddenly, it began to look as though Wal-Mart had saturated the market, and its days as a growth juggernaut seemed to be over. The company's earnings continued to grow, albeit at a more modest rate of 10% to 15% annually, but its valuation eroded at about the same rate as the market lost confidence in Wal-Mart's future. As a result, its formerly robust stock stayed flat and actually lost a little ground between late 1991 and late 1996. From 1997 through 1999, Wal-Mart worked hard to turn itself around, improving profitability and trying to spur growth by expanding into new markets, particularly overseas. The market took notice of Wal-Mart's rejuvenation, propelling its stock to an 80% annualized return during those years. But this return, unlike those from the company's previous glory days, was fueled mostly by valuation. Wal-Mart's earnings grew 75% over that time, but its price/earnings ratio more than tripled, growing from 20 to 70. (Annualized, about 20% of that return came from earnings growth and 60% from valuation growth.) That valuation increase means that at the beginning of 2000, the market valued Wal-Mart's stock more on expectations of future growth than it had a few years earlier, no doubt enticed by the prospect of Wal-Mart becoming as ubiquitous in the rest of the world as it is in the U.S.

Falling Prices: The Internet and the Oil Industry

On the other side of the coin, a falling stock price can result from either deteriorating fundamentals or lowered expectations--or more often some combination of both. Notoriously volatile Internet stocks such as Amazon.com AMZN and eBay EBAY are classic examples of this phenomenon in the short term; their prices can plunge precipitously on just the hint of bad news or lowered expectations. But the same thing can happen over a period of months or years. For example, falling oil prices caused the stocks of oil drillers to sink steadily in 1998, even though many of the companies were still very profitable. Investors had become gloomy about the oil industry's prospects over the next several years, and so they bid oil-drilling stocks lower and lower. If those pessimistic expectations come true, the stocks will likely stay down. If the industry stages a recovery, however, those stock prices will follow suit.

Looking at the Long Term

Legendary value investor Ben Graham used to say that in the short term, the stock market is a voting machine, but in the long term, it's a weighing machine. That means that any stock can be bid up in the short term if enough people want to own it, but in the long term the company has to deliver results--in the form of earnings and growth--in order to justify that price. Any stock can likewise get beaten down if the market becomes pessimistic about the company or its industry, but it will only stay down if that pessimism turns out to be justified in the long term. Every stock's behavior results from a combination of fundamentals and valuation, and recognizing how these two factors interact can help anybody navigate the ups and downs of the stock market.

Quiz 209
There is only one correct answer to each question.

1 A stock's price is determined by:
a. The underlying company's fundamentals.
b. The underlying company's current valuation.
c. A combination of the two.
2 All else being equal, if a company's growth rate slows, its stock price will usually decline unless:
a. Investors choose to pay a higher valuation for the stock.
b. The company can cut its expenses.
c. The company increases its debt level.
3 In which situation would you expect a stock's price to increase?
a. Investors have low expectations for the company, but the company beats those expectations.
b. A company meets investors' high expectations.
c. A company misses investors' high expectations.
4 When Ben Graham said that in the short term the stock market is a voting machine, he meant that:
a. Investors' ownership of stock gives them voting rights for in the underlying company.
b. The stock market is inherently corrupt.
c. If enough people want to own a stock, the stock's price can increase even if the fundamentals are poor.
5 When would you expect a stock's price to be most stable?
a. When the underlying company regularly beats investors' expectations.
b. When the company regularly meets expectations.
c. When the company either misses or beats expectations by a large margin.
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