Why Company Profits And Share Prices Diverge

Share prices and reported profits frequently move in different directions over the same period. The relationship between them is real but indirect, and the gap has identifiable sources.

Price reflects the future, profit reports the past

Reported profit describes a period that has finished. A share price reflects what the market expects the company to earn over all the periods ahead.

The two therefore refer to different time frames, and there is no requirement for them to move together in any given year.

A company can report rising profits while its price falls, if expectations for the future have deteriorated during the same period.

The discount rate does much of the work

Future profits are worth less than present ones, and the rate used to convert them into a present value depends on prevailing interest rates and required returns.

When that rate rises, the same expected profits are worth less today, so prices fall without any change in the underlying business.

This effect is strongest for companies whose expected profits sit far in the future, which is why such shares react most to interest rate expectations.

Valuation multiples compress and expand

The ratio of price to earnings summarises how much the market pays for each unit of profit. It varies over time for reasons unrelated to any individual company.

A period can therefore combine rising profits with falling prices if the multiple contracts faster than profits grow.

Over long periods, changes in multiples account for a substantial share of returns even though they reflect sentiment and rates rather than business performance.

Share count changes the per-share figure

Total profits and profits per share are different measures. Buybacks reduce the share count, raising per-share figures without total profit changing.

Issuing new shares works in the opposite direction, spreading the same profit across more claims.

Because prices relate to per-share amounts, changes in the share count affect the relationship between company-level results and the price.

Accounting profit is not cash

Reported profit reflects accounting conventions on when revenue and costs are recognised, which need not match when money moves.

Cash flow measures are often followed more closely for this reason, particularly where large non-cash charges or heavy investment distort the reported figure.

A company can report a profit while consuming cash, or report a loss while generating it, which is why the two statements are read together rather than separately.