A:

Simply put: Yes, although the answer is more nuanced. 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-earnings (P/E) ratio 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 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. At its most basic, maximizing profits, and ultimately stock prices, depends 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.

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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