Is maximizing stock price the same thing as maximizing profit?

By Matt Lee AAA
A:

Simply put: yes. A company's stock price will factor in many different variables including the type of industry the firm operates in, but profits (or earnings) are a very strong proxy of a company's stock price. In the short run, a company's stock price can make small to large price adjustments, depending on news releases and earnings reports. In the long run, a firm's stock price will depend largely on the firm's overall earnings. So, earnings will be one of the strongest drivers for a company's stock.

The price-earnings ratio (P/E) is one metric used to evaluate how earnings are factored into a company's stock price. This ratio will differ from industry to industry, and firm to firm, because there are different earnings growth opportunities between individual industries and companies. The growth potential in an older industry versus a new industry may be quite substantial. For example, the potential for earnings growth in a rail company will differ from the earnings growth potential for a bio-tech company.

Over the short term, there can be many substantial price shifts in a particular stock, but the vast majority of these price shifts are due to the changes in potential future earnings. The same can be said about the long-term valuations of a stock: earnings will be the main driver of the stock's price. After all, investors will not invest in a company that is not making, nor will ever make, money. This is one of the reasons the tech-bubble burst: tech companies were trading at very large multiples - well into the hundreds - but they were not making any money.

Investors will also factor in more fundamental factors into a stock's price, such as management characteristics and the economics of the industry. All of these factors influence the earning potential of the firm. Good management will produce earnings and industry growth, which will boost firm-specific sales. In short, if you want to maximize your stock price, maximize your earnings in the long run.

To learn more about different ratios used in company evaluations, read our tutorials on the P/E Ratio or Ratio Analysis .

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