Factors Influencing Stock Prices and Valuation

External factors can influence the valuation of a company, often beyond what is shown on the company’s financial statements. An interesting example of such a factor is found in a recent study that explains how stock prices increase when the government reports that unemployment and inflation are rising. “We find that on average an announcement of rising unemployment is ‘good news’ for stocks during economic expansions…Thus stock prices usually increase on news of rising unemployment, since the economy is usually in an expansion phase.” (Boyd, Hu, & Jagannathan, 2005, p. 1). Company value and stock prices rise on bad employment news because investors know that such news signals a drop in interest rates. Hence, we saw the rapid recovery of the stock market after the recent recession, even while the job market struggled to bounce back. Yet just as they sometimes inflate perceived value, external factors can drive a company’s valuation down as well. Scandal and public relations missteps can keep investors away even as profits remain steady.

Executives within a company work to maximize value through strategic methods. In short, they do so by managing their available capital deftly. “The guiding principle of value creation is that companies create value by investing capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital.” (Koller, Goedhart, & Wessels, 2010, p. 4). Profitable growth is important, but wise investment of raised capital can propel a company’s value upward. “The combination of growth and return on invested capital (ROIC) relative to its cost is what drives value.” (Koller et al., 2010, p. 4). The study goes on to explain that this winning strategy is only achieved when the company maintains the key factor in business: competitive advantage. When a business maintains a competitive advantage and manages its capital efficiently, this will be reflected in its ROIC and the perceived value of the company will rise, regardless of its balance sheets.

References

Boyd, J. H., Hu, J., & Jagannathan, R. (2005). The stock market’s reaction to unemployment news: Why bad news is usually good for stocks. The Journal of Finance, 60(2).

Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and managing the value of companies. John Wiley and Sons.