How Fundamentals Drive Stock Prices

Strong fundamentals drive stock prices higher over the long term. Expectations of better fundamentals, like stronger earnings, drive prices higher over the short term. If you are buying synthetic stock using LEAPs contracts you need to pay attention to long term fundamentals and for most shorter term option trading knowing how the market will react to expectations is equally or more important. Understanding how fundamentals drive stock prices is important in option trading.

What Are Stock Fundamentals?

Stock fundamentals are the things that affect how much money a company will make in relation to its assets. Long term investors are interested in a company’s intrinsic stock value which is the company’s ability to make money and to increase how much money it makes in the coming years. The price to earnings ratio, which is the price of the company’s stock divided by earnings per share, offers a usful look at how strong the company is and how well its share price represents the company’s value. Fundamentals also include cash on hand, absence of excessive debt, and the strength of both products and R&D within its sector.

Is Growth a Fundamental?

We generally think of fundamentals in terms of cash flow, money in the bank, and great financial reports. However, the intrinsic value concept says that you need to look at projected earnings when assessing the current share price. When intrinsic value, in terms of projected earnings, exceeds the current share price a stock should be purchased and when the intrinsic value is less than the share price it is time to sell. When a stock has growth potential, many investors are willing to pay a premium. In retrospect one could have paid a large premium to buy Microsoft when it first went public and still own a stock today that is worth hundreds of times its purchase price. Many investors see Tesla as a similar investment and are paying way too much if you simply value it as a car company. Sometimes the premium paid for a growth stock is simply based on hope and doomed to fail. And other times it is based on insight and likely to pay off handsomely.

Customer Loyalty as a Fundamental

Warren Buffett is a famous long term investor who says that he only invests in a company when he understands what they do to make money and how their approach will continue to make money into the distant future. He believes strongly that customer loyalty to a brand or brand name is an important fundamental. His holdings in Berkshire Hathaway include $130 billion of Apple and $21 billion of Coca Cola. He avoided tech stocks for years because he believes that today’s tech winner can be too easily replaced in five years. What impressed him with Apple was the almost fanatic loyalty of its base of customers worldwide. Thus he has steadily increased his Apple holdings and has been rewarded for his view of customer loyalty as a fundamental.

How Fast Can Fundamentals Change?

For most companies fundamentals strengthen or weaken gradually over time. A specific case where fundamentals can change virtually overnight is with small biotech stocks. A small biotech company can have a potential blockbuster drug going through FDA trials. These trails are mean to demonstrate safety and then efficacy. A drug that can cure a major type of cancer, diabetes, Alzheimer’s or any other major disease has the potential to generate monster sales and profits. The problem for investors and traders is that a drug can be doing well and then fail miserably at a given level of FDA trials. If it passes the stock price shoots up and if it fails the price plummets. Because fundamentals in such a case can change radically in a heartbeat, options trading is an excellent approach to locking in profit potential and hedging against loss.