What Do Share Prices of Companies Reflect?

Reproduced with permission from Tata Mutual Fund

There is a difference between the price of a share and its intrinsic value.  This is because while the share price represents a company's valuation, it is dependent on several macro- economic factors as well. So it is not just the performance of the company that matters. Also when the profitability and outlook of profitability comes down, the price can follows suit because “price of the share of a company” is a function of profitability expectation of that company.

Below are the various parameters that have a bearing on share prices.

1. Inflation: When inflation is high, people have less money to buy goods. Hence the demand for goods and services comes down. This reduces profitability of the company which in turn brings down the its share price. Also when inflation is high, the input costs for companies soar and many times companies do not pass this increase on to consumers. At such times, the company takes a hit by way of margin squeeze which brings down both profitability and share price.
2. Interest Rates: When interest rates go up, companies are directly impacted as their interest costs increases. This may bring down profits and the outlook of future profits if the high interest rates are expected to sustain. When profit outlook comes down, the share prices too tend to move down.
3. Currency Devaluation: When currency gets devalued or expectations of devaluation sets in, the interest of foreign investors could start to decrease. For example, if an international investor invests $100 when the value of the rupee was Rs. 50 (this means the person bought Rs 5000 from the $100). Subsequently if the value of the rupee decreases to Rs 55 to a dollar, then one can only recover about $90 from the Rs. 5000) which one purchased. Thus the returns are adversely impacted in a depreciating currency scenario.  Hence during such times, foreign investors are hesitant to invest and sell off Indian shares, converting the proceeds into dollars and fleeing Indian markets. This sale of shares initiated by them would bring share prices down.
4. Government Spending: A government that borrows in excess and overspends reduces the money available in the system. Private companies either have to make do with limited finance which hampers its growth plans or it has to borrow at higher interest rates which brings down its profit growth outlook and hence its  market capitalization (price). This phenomenon is what is popularly termed in finance as “crowding out” of private investments. Also one must understand that overspending on part of the government can lead to inflation if the supply of goods and material is inadequate. Inflation itself has an adverse impact on share prices as explained in the section on “inflation”.
5. Fiscal Deficit and Current Account Deficit: When the government spends more than it earns (imports more than it exports), it either borrows at higher prices which raises interest rates in the economy or it has to print notes to meet the deficit. In the case of printing currency without equal economic activity, the value of money goes down or in other words “inflation” kicks in. Thus higher interest rates, inflation and devalued currency impact cost of input and demand of goods and services unfavorably. This impacts company profitability and brings down share prices.

There are several macro-economic factors that influence share prices. These factors are inter-related and play a vital role in creating negative or positive sentiments among investors as the case may be. So even if a company is performing steadily and having reasonable operational profits, the macro-economic outlook plays a significant role in determining its share price.