ABSTRACT
In the long run, share prices move in line with profits and earnings per share. The rate of change is frequently out of step, but the timing of stock market changes in direction is closely allied to the turning points in the profits cycle. Over a period of ten years or more the two series will often diverge for a number of years, but in the long run the share price level will reflect the underlying development of corporate profits fairly closely.
Although external factors bearing on profits, such as interest rates, are beyond the firm’s control, the management will focus attention on sales, costs and investment with the object of optimizing profits and the company’s share price. The aggregation of company profits into a figure for the company sector as a whole provides a measure and a benchmark for judging an individual company’s performance which will also be useful in assessing share prices.
It is of the greatest importance to have estimates of profits and cash flow, since the timing of changes in profits is critical so far as management decisions are concerned. Similarly, the connection between share prices and the profit cycle underscores the need to have reliable forecasts of profits for the company sector as a whole as an indicator of likely turning points for the stock market.
A study of the general trends in profits in the economy as a whole provides the firm with a check on the sales and cost forecasts used within the company. A comparison of the general profit trends with the forecasts of the company’s profits will focus attention on the assumptions used in the forecasts. There may be special factors working either for or against the firm of particular relevance to cost and price trends and changes in market share.
