Investing in stocks is a great and proven way to build wealth. However, it is important to understand the inner workings of stock markets in order to succeed.

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For instance, how do the earnings of a company affect its stock prices?

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A snapshot of a company’s fundamentals

It is routine practice for publicly traded companies to announce their earnings periodically through quarterly and yearly financial reports. These earnings reports give shareholders and the public a look into a company’s performance while providing a basis for making projections.

This is because if investors compare the past and present earnings report of a company, they can determine whether a company’s fundamentals like its profits and debt-to-asset ratio are improving or declining.

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Determinant of investor confidence

If an analytical comparison of a company’s past and present earnings reveals an improvement in the company’s fundamentals, investor confidence in that particular company goes up. Similarly, if the comparison shows a decline, investor confidence also declines.

However, it must be noted that there is an element of unpredictability to this assertion. For instance, if a company’s earnings improve by a margin lower than was expected, investor confidence may drop.

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How stock prices respond

Since stock trading is largely speculative, investor confidence or market expectation have a significant impact on the movement of stock prices. If investors are confident that a company’s performance will continue to improve, the demand for that company’s stock goes up.

This high demand then stimulates an increase in the prices of the company’s stock until equilibrium between the incentive to buy and sell is achieved. On the other hand, if an analysis of the entity’s earnings predicts a downward trend, demand for stock falls.

Correspondingly, the stock prices fall and shareholders rush to sell their shares. In this way, the earnings of companies affect stock prices and result in market movements as per investor expectations.

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Price-Earnings Ratio

Due to the correlation between earnings and stock prices, there is a documented metric used to express the relationship between the two variables. This metric is a ratio known as the price-earnings ratio alternatively called the P/E ratio.

The P/E ratio is obtained by dividing the price of a share by the yearly earnings per share of a company. Essentially, P/E ratios express “how much investors are willing to pay for $1 of a company’s earnings.”

Therefore, if a company’s P/E ratio is high, it shows that investor confidence is high and expectations are that earnings will increase in future. A low P/E ratio on the other hand indicates that a company’s stock is undervalued because investors want to pay lower for earnings per share.

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Conclusion

It should be noted that earnings can in no way be considered a perfect indicator of a company’s future financial performance. Rather, earnings are just useful in observing an entity’s performance trend and in conjunction with other indicators, making investment decisions.

Therefore, earnings do affect stock prices and investors should always take the time to analyze earnings of a company before buying stocks in it.

You can find out more information like this on Alinea Invest.

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