Decoding share price movements

Executive teams are often frustrated by their firm’s share price. If they’re working hard and the company is in great shape, why isn’t the share price reflecting this? CEOs regularly ask IR directors, ‘Why did our share price fall (or rise) yesterday when we didn’t announce anything?’ Simply replying: ‘That’s the way the market works and it has nothing to do with our firm’ doesn’t explain why the company share price has fluctuated without a new company action or strategy change.

Before buying shares, big investors and fund managers calculate what they think a firm’s share price can achieve over the following 12 months. Knowing how these calculations are made is the first step to understanding the share trading process.

Secret formula
Fund managers have different formulae for calculating this future share price. Each formula is part of the fund manager’s individual intellectual property, which gives it a competitive advantage over other fund managers; it is not something they will easily divulge. The quality of research fund managers conduct, and their choice of formula for their calculations, improves the accuracy of their share price predictions – which ultimately improves the performance of their fund.

To explore what’s going on, let’s use the managerial capacity concept. Imagine the Acme Widget Company’s executive team calculates it should be producing 5 mn widgets a year. But the firm is producing only 3 mn widgets. Therefore, it has a spare capacity of 2 mn widgets. Now translate this into the maximum share price a company can reach over the next 12 months.

Let’s say capacity is equal to maximum company share price. This share price is calculated using the formula of price multiplied by earnings, or a specific multiple multiplied by free cash flow. Researching the company’s likely profit over the next 12 months – and therefore the likely free cash flow – is reasonably easy. Management teams regularly deliver IR presentations to the market giving their expectations of company performance over the next 12 months. Suppose the company says, ‘We’ll make $1 bn profit, or $1 bn free cash flow.’ If the investor applies the industry benchmark multiple of 10, for example, the company valuation is $10 bn. Divide the $10 bn by the number of shares to calculate the share price.

Seems simple? The complication is whether the company will ever reach the predicted $1 bn. Some fund managers’ research might suggest the company will exceed that target, so they believe the share price should be higher. Other people’s research may suggest the company will undershoot $1 bn. But the fact that this calculation includes a multiple means that, obviously, the final share price depends on which multiple an investor uses. Some will rate the company higher than the industry benchmark of 10, while others will rate it lower. For example, investors with a long-term horizon are likely to operate some form of discounted cash flow model to value listed shares. Short-term investors are more likely to use relative valuation techniques.

There are several variables affecting the maximum share price a company could reach over the next 12 months. Ultimately, however, investors’ predictions are based on information given to them by management teams. Providing investors with accurate information makes them better able to predict share price, gives them confidence in the company and the management team and increases the likelihood they will buy. If you overestimate profit, however, investors will stop believing forecasts, making them less likely to buy your stock.

Fund managers operate in line with their predictions, so fund manager A’s rationale might run like this: ‘I believe the maximum profit this company could make in the next 12 months is $X. If I apply the multiple of Y, then $X x Y divided by the number of shares = the share price. Unless the company reforecasts an increase in $X, or gives information suggesting I should increase its multiple, I’ll stick to my belief that the maximum share price for the next 12 months is $X times Y.’

Glass completely full
Capacity in this sense is like a glass: there’s only so much water it can hold. Whether you’re talking about widgets or a company’s share price, the maximum is capped by the top of the glass. Suppose $X x Y divided by the number of shares equals a calculated maximum share price of 80p. Having calculated the 80p, the fund manager looks at the actual share price, which might be 77p.

The cheaper the share, the greater the potential return. If the stock trades at 72p, and could reach 80p, the portfolio manager could make a 10 percent return. If the company is trading at 60p, the investor can make 20p per share – a 30 percent return. This makes the stock more attractive.

There are further variables, such as how much uplift fund managers require and the need to include certain types of company in their portfolio. Some stocks deliver income, some offer growth opportunities and others offer a mixture of dividends and growth.

If the company’s maximum share price is 80p, and it gets up to 77p, a fund manager might say, ‘This is close to the top, so I’ll sell some and make a profit. I’ll put that profit into my portfolio and when the share price drops down to 72p I’ll buy back the shares.’

If enough fund managers all act in the same way at the same time, the stock price goes from 72p to 73p, then to 74p and up to 77p. At 77p it suddenly gets sold off and goes back down to 72p again. This yo-yo effect will send the CEO into the IR director’s office asking, ‘Why can’t we get past 77p?’ The simple answer is investor activity. Investors know the company could reach 80p. But they also know other investors won’t buy the stock at that price so they sell the stock anywhere close to 76p and make a profit.

Although the maximum share price is believed to be 80p, market forces dictate that it never gets there. Remember the Acme Widget Company? Although the management team has calculated maximum production capacity at 5 mn widgets a year, the reality is that every year some unforeseen factor scotches that target: mechanical breakdown, flood, power failure. The company never reaches 5 mn widgets, even though the theoretical capacity calculation says it should.

Share price operates the same way: once the share price gets close to capacity, everyone sells. If the sell-off always occurs at 77p, fund managers will prefer to jump in early and sell theirs first, ensuring they make a profit. As a result, companies consistently get to within 5 percent to 10 percent of their maximum share price, but never reach it. This is a constant source of frustration for management teams.

Hitting targets
Fund managers are traders of stock: they may invest over different time horizons but, once the shares hit the managers’ price target, they will trade out of the stock. Although management teams know investors trade shares, they don’t always link this to the technical calculation of the share price maximum.

Regardless of whether your company is the market leader, portfolio managers will buy the stock of the company that will provide the biggest growth uplift. When money comes out of the number one company and goes into number two and three for a cycle, the CEO of the best company will then inevitably worry the other two companies have got a better strategy and spend the next six months agonizing over what these might be. But share prices here have nothing to do with management strategy – and everything to do with portfolio management.

You can tell a lot from watching the stock of the market leader: when investors think the market is going to turn, they tend to go for safety and put money into the market leader. In typical market conditions, however, when the gap between the leader’s share price performance and the next company is high enough, investment money comes out of the leader and goes into the next tier.

For the next few months, investment pours into market followers and their share price catches up with the leader. Eventually, the gap between the leader and the rest becomes small. Investors then reinvest in the leader’s stock. Investment money comes out of the second tier and goes back to the leader. The leader takes off again until the gap widens between it and the second tier. The money then comes out of the leader and back into the second tier, and so the cycle begins again.

Sector specifics
Although your company might be rated the best in its industry sector, it might not be traded using a high multiple. Investors will look across whole economic segments as well as industry sectors when managing their portfolio. And portfolio managers don’t buy into every sector. Suppose sector A looks reasonably priced, with maximum share prices around 80p, and trading around 72p. But in sector B the maximum is 80p, while trading is around 60p. It won’t matter if you’re the best within your sector if there’s a peer company with better opportunities. Investors will put their money there instead.

Perhaps your company does well but pays low dividends. Investors may think there are other companies giving them a 5 percent yield. If your company is not offering the same growth, investors may invest elsewhere. At this point, unless you’re willing to switch your dividend policy, money won’t come into your sector.

Investors have a prediction for maximum share price over the next 12 months unless companies adjust that maximum. Issuers can do this by announcing that earnings will be higher than forecast, or by demonstrating that the company is better than investors believe it to be.

Companies should indicate earnings will be higher than forecast only if they are reasonably certain they will be. As long as they are sustainable, it will increase your maximum capacity. If this doesn’t explain your firm’s share price movement, you need to look outside your company and to your peers. If that still doesn’t provide an answer, you need to look across your sector.

Executives spend an inordinate amount of time worrying about how investors view their strategy and believe the small daily, or monthly, share price movements are a judgment against it. In reality, share price movements very rarely relate to management strategy; they’re simply investor portfolio management. An alternative way to increase the maximum capacity of your company is to positively change investors’ views of the multiple.

Ian Roundell is head of investor relations at Credit Suisse.