Question

How does the concept of “profit” contrast with the concept of “value” when talking about share price? There is often a great deal of focus on “earnings-per-share”; explain why this may or may not be a reliable determinant of stock price increases or decreases. Explain in 200-500 words.

Answer 1

The price of a share is based upon the value of a business rather than simply the profitability of the same. Financial Management is responsible for setting the financial objectives of a business. Profit maximization is a short term objective that assures the growth of capital but ignores the risk and uncertainty involved in the decisions. As a result focus on profits can generate short term games for the business but ignore the long-term value of the business. This will result in a reduction in the share price even though the profitability of the business maybe hai since the share price also takes into account the growth prospects of the business.

Value maximization on the other hand is a long-term objectives that undertakes decisions to increase the market value of the stock over time. Market value of the firm is based upon many factors and more importantly the growth rate of the business. Hence the share price of a company is dependent upon the concept of value.

The earnings per share metric may not be a reliable determinant of stock price changes. This is because the value of a stock is determined by the cash flows arising to the investor from holding that stock. Hence the value of dividends discounted at the required rate of return would be a better determinant of the stock price rather than earnings per share.