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 .

RELATED FAQS
  1. Why is the PEG (price to earnings growth) ratio something I should be looking at ...

    Understand the price/earnings to growth ratio and why it may be a better stock valuation tool than the more widely used price-earnings ... Read Answer >>
  2. What are common growth rates that should be analyzed when considering the future ...

    Learn about some of the most commonly used measures for evaluating a company's future growth prospects and analyzing it as ... Read Answer >>
  3. What is considered a good PEG (price to earnings growth) ratio?

    Learn about the price/earnings to growth (PEG) ratio and understand what investors and market analysts consider a good ratio ... Read Answer >>
  4. When does a growth stock turn into a value opportunity?

    Learn how fundamental analysts use valuation measures, such as the price-to-earnings ratio, to identify when a growth stock ... Read Answer >>
  5. When computing the PEG ratio for a stock, how is a company's earnings growth rate ...

    Remember that the price/earnings to growth ratio (PEG ratio) is simply a given stock's price/earnings ratio (P/E ratio) divided ... Read Answer >>
Related Articles
  1. Investing

    The 4 Basic Elements of Stock Value

    Investors use these four measures to determine a stock's worth. Find out how to use them.
  2. Investing

    Comparing the P/E, EPS And Earnings Yield

    Here are three ratios that help investors value stock returns.
  3. Trading

    Forces That Move Stock Prices

    You can't predict exactly how stocks will behave, but knowing what affects prices will put you ahead of the pack.
  4. Investing

    SXC Health Solutions Corp. (USA) Among the Nasdaq's Biggest Movers

    The market is having a bad day so far: the Nasdaq is trading down 0.3%; the S&P 500 has declined 0.4%; and the Dow has slipped 0.5%. The Nasdaq Composite Index is a capitalization-weighted index, ...
  5. Investing

    How To Make A Winning Long-Term Stock Pick

    Discover the key elements of a good long-term investment and how to find them.
  6. Investing

    Understanding The P/E Ratio

    Learn what the price/earnings ratio really means and how you should use it to value companies.
  7. Investing

    Everything Investors Need To Know About Earnings

    We go over the concepts behind the excitement over the most important figure in the stock market.
  8. Investing

    5 Must-Have Metrics for Value Investors

    These quick-and-dirty ratios will help you find the most undervalued stocks on the market.
  9. Investing

    Beware False Signals From The P/E Ratio

    The P/E ratio is a simple tool for evaluating a company, but no one ratio can tell the whole story.
RELATED TERMS
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  2. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  3. Long Run

    A period of time in which all factors of production and costs ...
  4. P/E 30 Ratio

    The price-to-earnings (P/E) ratio is the valuation ratio of a ...
  5. Short Run

    In economics, it is the concept that within a certain period ...
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ...
Hot Definitions
  1. Time In Force

    Time in force is a special instruction used when placing a trade to indicate how long an order will remain active before ...
  2. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  3. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  5. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  6. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
Trading Center