Drivers of Equity Prices and Changes in their Valuations

Drivers of Equity Prices and Changes in their Valuations

        The equity of a company (also known as stock or share) is a financial mechanism that characterises ownership within a corporation and signifies a balanced claim on its earnings and assets. Earnings being what the company makes in profit and assets being what the company possesses. Equity prices vary daily through market forces, i.e. where buyer demand is met by seller supply. Unfortunately, there is no exact explanation that defines precisely the behaviour of equity prices. In understanding the behaviour of these prices, present research typically creates a portfolio based on the company’s characteristics, the measure of value or previous stock returns. Due to the extensive number of factors affecting stock price changes, there is a need to have clarity regarding if any given element has unique information. This information helps us understand the changes in stock prices. The factors of the stock market are the ones that govern changes in equity prices and expected returns (Cochrane, 2011). Therefore, these factors are the key to understanding changes in equity valuations.

Changes in the stock market factors are as a result of economic or market risk variables. The factors to affect equity price changes should contain information that relates to the fundamental economic state variable. These factors need to exhibit a causal relation with the macroeconomy. Supply factors that impact stock prices comprise of stock issues, sellers, and stock buybacks. Stock issues exist when a company announces new stock to the public. The number of stock in circulation is usually limited for most companies. Therefore if the majority of the investors will want to buy a stock at such a period, the stock price will rise. Sellers are investors accountable for pushing the stock back into the market, thus increasing supply. They usually sell the stock when they anticipate a reversal, for-profit, or when they believe the stock’s value is decreasing. A stock buyback arises when a company buys back its shares from investors to decrease supply. These stocks are either kept for future redistribution or become cancelled.  Reducing the number of stocks in supply increases the stock price and the earnings per share of the company (Killian Anzel, 2020).

Demand factors which can influence stock prices include economic factors such as inflation, exchange rates, and interest rates, industry trends and market sentiment. A higher percentage of inflation produces a higher discount rate, thus a lower multiple. This statement means that the future earnings of an investor will be worthless in inflationary situations. Low inflation has a robust inverse correlation with valuations which means low inflation pushes for high multiples and high inflation accelerates for low multiples. The valuation multiple usually articulates the future expectation of earnings. Larger firms display more robust fundamentals and are current winners when inflation rises.

The portfolio balance approach tries to explain the relationship between exchange rates and stock prices. This basis of this approach is on the notion that the firms’ market value can be considerably affected by the strength of the county’s currency. However, it is vital to recall that the exchange rate market is extremely unpredictable, so any influence on the stock prices tend to lag. Similarly, until a company publicises its earnings report, investors cannot fully comprehend the degree to which exchange movements have influenced their stock prices and operations. Even though the relationship between exchange rates and the stock prices exists, it may be hard to use it as a stock price movements’ indicator (Becca Caitlin, 2020).

The decrease in interest rates witnessed globally ever since the financial crisis has affected stock prices. Although the company’s value may not move in itself, a decrease in discount rates caused by an interest rates reduction will have an impact. It should not be a surprise that stock prices have realised a series of all-time highs in diverse countries at a period of generally low interest rates which is justified and understandable. The influence that interest rates have on stock prices is difficult for anyone to foresee with certainty. That said, investment procedure which is value-oriented is mainly aimed to take advantage of overreaction into the broader market (Kevin Murphy, 2018).

For factors of the stock market to have any meaning economically, they must display some relation with economic variables. Inflation, exchange rates, and interest rates play a significant role in explaining the equity price movement. Accurately, equity price changes reflect expectations concerning future changes in economic conditions. Forecasting exercise through time-series approach considers a range of economic and statistical forecast metrics and undertake forecast for an individual variable set. The improvements for forecasts that are economic-based are noticeable as compared to that which is statistical-based (Black AJ et al., 2014). The FF5 and FF3 equity pricing model adds value in explaining stock return behaviour. The FF5 provides any information over above the FF3 model as both models attain the same trading performance. Notably, time-variation in these factors changes their economic interpretation. Comprehending why changes in equity prices occur is of significant importance. However, further research can be done to improve the equity pricing debate as well as posing questions for future research (Fama & French, 2015).

References

Becca Caitlin. 2020. “What is the relationship between exchange rates and stock prices?” IG Markets Limited. London, United Kingdom.

Black, A. J., Klinkowska, O., McMillan, D. G., & McMillan, F. J., 2014. “Predicting stock returns: Do commodities prices help?” Journal of Forecasting. 33, 627-639.

Cochrane, J. H., 2011. “Discount Rates”. Journal of Finance. 66, 1047-1108.

Fama, EF & French, KR. 2015. “A five-factor asset pricing model”. Journal of Financial Economics. 116, 1-22.

Kevin Murphy. 2018. “How do Interest Rates Affect Stock markets?” The Value Perspective. The United Kingdom.

Killian Anzel. 2020. “What Causes Share Price to Change?” IG Markets Limited. The United Kingdom.