Whenever a tech company’s result announcement results in a share price drop, tech journalists around the world pontificate about what it means. Fans of a particular company rally to defend it and seem to take it very personally that the stock market doesn’t seem to understand how good the company’s products really are.
A little basic finance knowledge would be of use here to get an inclining of why the market often reacts in the way it does. I present here a bit of Finance 101 and the Dividend Discount Model. Don’t be afraid – it’s quite simple involves just one formula:
This model considers a company, specifically a share of a company, as a black-box that spits out money in the form of a dividend. How much would you be willing to pay for such a black-box? The formula gives us the answer to that question, .
The first factor is the size of the dividend . A larger dividend gives us a larger .
We also need to take time into account. A dollar now is worth more that a dollar received in one year’s time. In simple terms, you can think of this is as inflation. Slight more accurately it is opportunity cost – a dollar put in the bank will accrue interest over that one year. The formula expresses this as .
The final factor is the growth rate of the company, specifically the growth rate of the dividend. If your black-box will spit out larger amounts in the future, it is worth more. This is a negative in the denominator, so higher will give us higher . Of course, we don’t know in advance what the black-box will spit out – or the company will pay out in dividends – so we estimate it based on the track record and whatever other information we have to predict the future growth rate.
This growth rate is the key value for understanding drops in stock prices after ‘poor’ earnings announcements. If the market suspects – or receives direct evidence indicating – that a stock’s future growth isn’t as big as previously thought, then the price will drop.
Of course, then nuance comes into play. Maybe this quarter was an exceptional one due to special conditions, maybe the company has a big announcement around the corner. Different investors will have a different view of what for a company is.
Many other factors come into play – not all of the company’s earnings are paid out as dividends and so on and so on. The Dividend Discount Model is far from the final word in share pricing, but identifies some important factors that serious investors will be considering in valuing a company.
So, next time your favourite tech company’s price drops, don’t take it personally. It is just a bunch of investors reevaluating their estimate of a company’s value.