Investors' Perceptions in a Rational Market
Wouldn't it be great if you could explain why everything happens? When investors make informed intelligent decisions, share prices change according to the laws of supply and demand. These changes subsequently affect the PE and investors' perceptions - and again, alter the share price. Therefore, the point at which all these factors converge is known as the "fair market price" for a share price. In a perfect world, it all makes perfect sense.
A hypothetical history of Ella's Elegant Dresses show how all these factors come together at different points in time.
Ella's Elegant Dresses Quarterly EPS Information: (reported at the end of each respective quarter)
| Q4 | Q1 | Q2 | Q3 | |
|---|---|---|---|---|
| Share Price (end of Quar.) | $20.00 | $30.00 | $25.00 | $45.00 |
| EPS | .75 | .75 | 1.05 | 1.25 |
| PE | 26.7 | 40 | 23.8 | 36 |
After viewing the above numbers, investors might be inclined to perceive the information in the following manner. Possible explanations for each quarter are described below.
| Q4 | Q1 | Q2 | Q3 | |
|---|---|---|---|---|
| Investors' Perceptions | Positve | Negative | Positve | Positve |
Quarter 4
Perhaps Ella's has a PE (26.7) lower than that of many other clothing designers with similar earnings. (For this example, we might even say that clothing designers in general have PEs close to 33.) Or perhaps the PE for the entire clothing industry may be low compared to other industries, making most clothing businesses attractive investments. Investors may also feel that the entire industry (or Ella's, in particular) is due for an increase in growth, perhaps due to a baby boom, a new law, changing social values, etc..
Quarter 1
The price rises to ($30.00) and at the end of the quarter Ella's EPS is reported at 0.75. The resulting PE (40) is seen by investors as pricing the stock as too expensive. This rise in price also occurred without any increase in the EPS. Subsequently, some investors will sell their shares during the early part of the second quarter.
Quarter 2
The sale of some shares brought the share price down to $25.00 and should have resulted in a PE (33) that was more acceptable to investors. However, at the end of the quarter, Ella's reported an increase in EPS (from .75 to 1.05) and the resulting PE (23.8) is now seen by investors as very attractive.
Quarter 3
In theory, investors should buy shares to drive the price up to $35.00 so that it results in a fair market PE of 33 ($35.00 / 1.05 = 33.3). However, after the increase in EPS (from .75 to 1.05), investors are now willing to buy shares even when the resulting PE would be over 33. They are doing this because they are buying shares on the anticipated increase in future earnings. The investors' prediction turns out to be true when the EPS increases again to $1.25. This puts the PE at 36, and again investors must decide if this PE makes the stock too expensive.
Please note
The table and explanations above are unrealistic for at least two reasons:
- The PE ratio above is taken from the current share price and the quarter's EPS, not the previous year's (4 quarters) EPS as it should be.
- The numbers represent a simplified, and very sequential, progression of a normal market. In reality, these factors occur simultaneously at all stages.