Maximizing stock prices and maximizing corporate profit are significant goals for any company. Both are needed for a company to grow and both reflect the overall health and wellbeing of the company. But are they the same idea? Simply put: Yes, but the full answer is more nuanced.
- Maximizing a company's profit and maximizing the stock price speaks to the same ultimate goal: seeing a company thrive and make money for its investors.
- While the goal is the same, the drivers of profits and stock prices are slightly different.
- Stronger profits and upbeat forecasts are among the factors that drive up stock prices, though there are also industry-specific and economic factors at play.
- Other factors that influence stock price include the perception of management, new product launches, and any developments within the particular industry.
How Profits Impact Stock Prices
While a company's stock price will factor in many different variables, including the type of industry the firm operates in, its profits (or earnings) are a very strong proxy for the 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, or profits, will be one of the strongest drivers for a company's stock.
The price-to-earnings (P/E) ratio looks at a firm's current stock price relative to its per-share earnings, so as to assess the value of a company's shares; generally, a higher P/E ratio suggests higher growth.
How the P/E Ratio Works
The price-earnings (P/E) ratio is one metric used to evaluate how earnings are factored into a company's stock price. There is no one ratio that is appropriate to consider for all stocks. That's because the ratio will differ from industry to industry and firm to firm since 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 biotech company, simply because railroad transportation is a known entity with finite possibilities, while the possibilities in the biotech sector are virtually limitless.
Thinking About Tomorrow
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.
The Bottom Line
At its most basic level, maximizing profits and ultimately stock prices depend on increasing revenues and decreasing costs associated with the products or services sold. Good management will produce earnings and industry growth, which will boost firm-specific sales. In short, businesses that want to maximize their stock price will work toward maximizing earnings over the long term.