What really makes a particular stock go up or down? Although there are many ways of valuing a business, the most common approach to rating stocks is by the total profits earned by the company each year. When assessing a stock’s worth, it’s all about the profits. The biggest secret Wall Street wizards keep is how much of an impact company profits have on a stock. It’s all about the profits, it’s always about the profits. Profits the company is making today, and what is expected in the future. This simple, yet powerful, rule is what has driven stocks in the stock market since the 1800s, yet mainstream America is unaware of what really pushes individual stocks higher. Why then is it such a secret? It’s rarely discussed in financial conversations.
What really moves a stock?
If you look back at the biggest stock market winners during our generation, the Wal-Marts, Microsofts, Home Depots and Dells all had one theme in common—they grew profits at ferocious speeds. If you want to own stocks that go up year after year at top growth rates, start looking for companies with the highest profit growth. It’s very important to understand the basics of this thesis to truly reach your investing potential. Every day we turn on the TV and listen to so-called experts tell us XYZ stock is going to be $40 because of such and such, or rumor has it Widgets Inc. will soon be bought out. When we take a step back and look at the big picture over an extended period of time, for example five to ten years, a company’s stock will reflect what the company was, or is, able to bring to the bottom line.
Investing in stocks is really just Business 101. Don’t try to make it more complicated than it is. When you think of Home Depot (HD) starting operations with just one store, it’s obvious they needed to make profits to help finance a second store. After a huge national expansion, today Home Depot boasts more than 1500 locations. Big profits were earned to warrant this kind of growth. Our ultimate goal is to find a company that will be worth more down the road than it is today. By becoming a partner/shareholder in a small business when it is making profits and correctly putting those hard earned dollars back into the business, which will eventually enable it to grow into a large corporation, we turn our small investment into a large one.
Why stocks get crushed when they miss estimates
Ever wake up and notice a stock you own is down, say 20 percent one day? This often happens when a company releases news that their profits haven’t hit analyst expectations. The smart money immediately knows this company is not worth what it was the day before, so they often sell that day and reallocate the proceeds on companies with more solid prospective profits. The inverse is also true. Many stock market leaders are companies that beat analyst profit estimates, and then guide yearly profits higher going forward. Since profits are coming in better than the market expected, the stock consequentially does better than expected. It’s all about the profits. Valuing a company based on its underlying profits is a long-term outlook. Over the short term, there are weeks or even months when the stock market gets slammed and just about every stock gets hit. We just went through one of these corrections during July and August. But when the dust clears and the market starts to pick back up, the smart money goes back to looking at the fundamentals. They look at the profits and decide which stocks give the most bang for their buck. Often, when the market turns up after a period of decline, the companies growing profits the fastest are the ones which race up the quickest.
How to avoid the stocks that crash and burn
The stock market declines we saw in 2000 and 2008 were due in part to profit growth slowing; the market simply followed the profits.
When Sun Microsystems’ (SUNW) profits rose during the 1990’s, the stock was a huge winner. When SUNW’s profits dropped — and eventually disappeared — the stock almost disappeared. So to avoid the stocks that crash and burn, sell companies that lose their ability to make profits.
The worst stocks during 2000-2002 were those without profits — many of those stocks crashed and burned. It is inevitable that they were due to decline (as was the case with many dot-com’s) because company losses cause cash to drain, forcing firms to consequentially shut their doors. Although it is impossible to go back in time and avoid the mistakes we have made in the past, we can focus on improving our situation, learning from mistakes and moving forward. Focusing attention on company profits when researching individual stocks is a big step in the right direction. It’s all about the profits.
