What determines the market price of a share of common stock? Like anything, price depends on what people are willing to pay. The price of a share of stock today depends on what investors believe is today's value of all the cash flows that will accrue in the entire future from that share of stock. In other words, no one is going to pay any more today for a share of stock than they think it is worth—based on what they think they will get out of it in terms of future cash flows. What people are willing to pay for a share of stock today determines its market value.
The theory of stock prices makes sense. If we could accurately forecast a company's cash flows in the future, we could determine the value of the company's stock today and determine whether the stock is over- or undervalued by the market. But forecasting future cash flows is difficult. As an alternative, what is typically done is to examine the historical and current relation between stock prices and some fundamental value, such as earnings or dividends, using this relation to estimate the value of a share of stock.
In this chapter, we take a closer look at the fundamental factors of earnings and dividends and their relations with share price, as expressed in such commonly used ratios as the price-earnings ratio and the dividend yield.
A commonly used measure of a company's performance over a period of time is its earnings, which is often stated in terms of a return—that is, earnings scaled ...