What is a stock price?

The obvious answer is “that’s how much you pay for a share”. But there is more to it.

Stock prices show us the market’s opinion of what a company is worth. It is the aggregated opinion of all the players in the market. This includes traders, short-term investors, long-term investors and speculators.

Stock prices are determined by the actions of each of these market participants. And the actions of each market participant is determined by his or her expectations for the stock.

For instance, if you expect a company to do well in future, you would buy the stock. If you expect it to do badly, you would sell the stock. Fundamental investors make these expectations explicit by forecasting financial statements for a company. They use this to estimate expected future cash flows. They then discount these cash flows to the present and add them up to estimate the value of the company. This method is called a discounted cash flow (DCF) valuation.

Changes in expectations drive stock prices

Stock prices can jump when companies release financial results. You might think the market is reacting to those results. This is not the case. Financial results contain historical information. But stock prices are based on future expectations.

What happens when companies release results is that the market changes expectations and the stock prices adjust accordingly. This explains the counterintuitive situation where a company releases positive results but the stock price drops.

In those cases, the market was expecting better performance and when the good results came out, the market adjusted their future expectations downward. That is why the stock price dropped in the face of good results.

Extracting information from stock prices

In certain cases, discounted cash flow valuation can be simplified from a spreadsheet full of numbers down to a simple equation. This equation is called the Gordon Growth model and it estimates the stock price (V) by using the expected future free cash flow to equity (FCFE), the cost of equity (r) and the expected growth in cash flow (g).

• V = estimated stock price

• FCFE₀ = free cash flow to equity

• r = the cost of equity

• g = expected growth rate of the free cash flow to equity

You can rearrange this equation to solve for the growth implied in the stock price:

Instead of using this equation to estimate the stock price today, you can insert the actual stock price (V), the cost of equity (r) and the current free cash flow to equity and it will show you the growth rate in FCFE that is expected by the market.

Three step process to use this information

As an investor you can use expectations in your investment process as follows:

1. Estimate the implied expectation.

2. Identify investment opportunities by analyzing the company’s prospects to determine if it can achieve, meet or exceed these expectations.

3. Buy, sell or hold the stock based on your analyses.

Example: Apple

Let’s illustrate this framework in a simple way using Apple.

Step 1: Extract growth expectations

This table shows 10 years of implied growth expectations which were extracted from Apple’s stock prices. The actual FCFE growth achieved in those periods is also shown.

Step 2: Identify opportunities

Over the past decade, you can see that the market had fairly steady expectations of growth in Apple’s FCFE. But the actual growth was far more volatile. In some years, it grew at a very high rate and in other years, it shrank.

Now let’s zoom in on the 2023 fiscal year, which ended six months ago. The market was expecting 11.2% growth, but FCFE actually declined by 10.5%. Since then Apple’s stock price has not been doing much. It was around $170 in September 2023, it went up but is now back down to $171 in March 2024. It’s fair to say that the market has adjusted its expectations for Apple since then.

Step 3: Buy, sell or hold

While implied growth and actual growth are not always directly correlated with share prices, it was clear that Apple did not achieve the FCFE growth that the market expected. This was due to slowing sales in some of its markets.

Based on that analysis you could have sold out of Apple and bought into something that had more attractive prospects.

Alternatively, you may not want to sell your Apple stock. Then this analysis might calm your nerves and help you stay the course with Apple because it would have alerted you to the possibility that Apple’s stock price might go sideways.

Conclusion

This technique can be a useful addition to the rest of your analyses.

I find it useful when stock prices are going crazy (like Nvidia’s price has been doing). It can help you to assess whether fundamentals and expectations are going out of kilter.

If you’re wondering what happened with Nvidia, their financial year ended in January 2024 and they released results on 21 February 2024. The next day their share price jumped 16% – this is a massive jump for such a valuable company.

Was that jump rational? I think it was. The implied growth expectation was 11%, but the actual FCFE grew by 2048%. With such a large discrepancy, clearly future expectations for Nvidia would have been revised upward and the stock price would adjust accordingly.

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