Question

What drives the value of a stock?

2. Is the current U.S. stock market over-valued or under-valued? Explain

Answer 1

Factors that drives the value of a stock are:

The marketplace determines share prices. While seller supply and buyer demand meet in the market, there is no perfect equation that lets investors know exactly how share prices will behave. However, there a number of factors that can move stocks up and down.

DEMAND AND SUPPLY

Demand and supply in the market affect the prices of shares. When demand for shares exceeds supply, which means the buyers are more than sellers, the prices increase. When demand is less than supply, meaning that buyers are less than sellers, the prices decrease.

INTEREST RATES

In case of lower interest rates, demand for funds is higher and the subsequent demand for shares rises. On the other hand, high interest lowers the demand for funds and the demand for shares is lower.

INVESTORS

Market players have an impact on share prices. With more bulls than bears, the prices increase. With more bears than bulls, share prices decline.

DIVIDENDS

Dividends indicate the movement of share prices. When companies make dividend announcements, the share prices of such companies are likely to increase. It is important to note that if the dividend rate announced is lower than the investors’ expectations, share prices decline while if they are up to more than expected, share prices increase.

MANAGEMENT

Management profile has a significant effect on company success and stock prices. If management consists of experienced professionals with a proven track record, share prices are likely to be higher. If the management that takes over a company lacks integrity, share prices tend to fall.

ECONOMY

Fluctuations in the economy feature what are commonly referred to as booms and depressions. Under favorable conditions share prices are at their peak and their lowest point is experienced during depressions. Share prices gradually rise during recovery and fall during recessions. Click here for live Lloyds share price.

POLITICAL CLIMATE

Political factors that range from relations with other nations to government policies can affect share prices.

SHORT-TERM AND LONG-TERM INVESTORS

Different investors rely on different factors. A short-term trader or investor is likely to prioritize and incorporate technical factors such as inflation, trends and demographics. Long-term investors focus on fundamentals like earning power and acknowledge the crucial role that technical factors play. Investors who prioritize fundamentals can integrate technical factors.

It is widely believed that market sentiment and technical factors are overwhelming on a short-term basis but fundamentals ultimately set share prices in the long run. Since conventional theories are not sufficient for explaining all the things that go on in the market, behavioral finance or market sentiment will always be a keen area of interest.

CONSIDERATIONS

• Stock prices change for various reasons. While some people believe that it is impossible to predict the changes, others think that observing past price movements and charts can determine when you should buy and sell.
• Stocks are volatile, which means that prices can rapidly change.
• Fundamentally, demand and supply in the market influence share price.
• Comparing the share prices of two different companies is not conclusive when determining the value of a company.
• Earnings affect how investors value companies but other indicators are used for the purpose of predicting stock prices. Stock prices are affected by investors’ expectations, attitudes and sentiments

Current Status of US Market: It is Overvalued

Although U.S. stocks have fallen sharply from their record highs, Goldman Sachs warns that "S&P 500 valuation is stretched relative to history." That may be an understatement. Goldman looked at nine valuation metrics for the S&P 500 Index (SPX) and found that the current values for seven of them are significantly above historic averages for the period since 1976, as detailed in the table below. The data is based on Goldman's report, which is appropriately named "Where to Invest. 2019 US Equity Outlook: The Return of Risk."

7 VALUE WARNING SIGNS
Metric	Current Value	Percentile vs. History
U.S. Market Cap / GDP	188%	98%
Enterprise Value (EV) / Sales	2.2x	91%
Cyclically Adjusted P/E (CAPE)	26.1x	81%
Price/Book (P/B) Ratio	3.2x	84%
Cash Flow Yield	7.6%	81%
Enterprise Value (EV) / EBITDA	10.9x	81%
Forward P/E Ratio	15.6x	75%

Significance For Investors

Despite a 1.5% drop in the value of the S&P 500 year-to-date through Dec. 7, seven of the nine metrics that Goldman studied are now registering higher equity valuations than 75% to 98% of the observations made since 1976. In the case of one metric — cash flow yield, which is the ratio of cash flow to stock price — the lower the figure, the higher the implied valuation. Thus, cash flow yield had been greater than it is now 81% of the time since 1976.

The current bull market has nearly quadrupled U.S. stock prices, as measured by the S&P 500, since it got underway nearly 10 years ago, in March 2009. As investor optimism about future corporate earnings growth has expanded during that time period, so have stock valuations.

The CAPE ratio has attracted particular attention from bearish observers in 2018, some of whom have cited it as signaling an impending market meltdown. It began the year at its second-highest reading ever for the S&P 500, above where it was before the Great Crash of 1929, and only exceeded by its value preceding the dotcom crash of 2000-02, as Investopedia discussed in detail earlier this year. The CAPE analysis uses inflation-adjusted average earnings per share (EPS) from the prior 10 years to derive equity valuations.

The developer of the CAPE ratio, Nobel Laureate in economics Robert Shiller of Yale University, has been warning that current market valuations are unsustainable for the long run, as discussed in another Investopedia report. He is particularly concerned about "the public's lack of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors," as he has written in an essay republished by MarketWatch.

One of the biggest causes for worry may be the ratio of total U.S. stock market capitalization to GDP, a metric favored by master investor Warren Buffett. While he apparently has not made recent public comments on the matter, this indicator has been flashing warning signs to other investors and market watchers, per an earlier Investopedia article. Meanwhile, Goldman's report presents three big risks for U.S. stocks in 2019 that make high-valuation stocks more vulnerable.

3 BIG RISKS AHEAD
Risk 1: Tariffs	2019 S&P 500 EPS may be 7% lower
Risk 2: Wage Inflation	Labor costs equal to 13% of sales for typical S&P 500 firm
Risk 3: Rising Bond Yields	Rapid rises in bond yields tend to depress stocks

Goldman finds that a monthly change of 20 basis points (bps) or more (either up or down) in the yield on the 10-Year U.S. Treasury Note has occurred in 44% of the months since 1962. When the yield rises by less than 20 bps in a given month, the S&P 500 can "digest" it, as Goldman writes. On the other hand, the index typically falls when the T-Note yield jumps by more than 20 bps.

In his essay, Shiller writes that "the U.S. stock market [is] the most expensive in the world," based on his CAPE ratio analysis. Given several other valuation metrics that also are well above the norms of recent history, and coupled with key risks such as those presented by Goldman, investors would do well to prepare for the possibility of yet more downdrafts in stock prices. If what Shiller calls "healthy skepticism about corporate earnings" starts to dominate investor psychology, the declines may be dramatic.