How stock price jumps?

Continuing our earlier discussion on What triggers stock movement ..

Let us take take an example to see how much of an impact can sales increase and profit margin increase have on the stock price. This is an important point because if the stock price is to go upwards, then Net Income has to go up (logically yes, but market can even drive stock price higher with just speculation). This can happen when either sales increases or profit margin increases.

Lets say company XYZ made $100,000 sales in their first year and Price to earnings (P/E) ratio is at 15. And if the profit margin is 5%, then,

Net income = Earnings = sales * profit margin = 100,000 x 5% = $5,000

Assuming 1000 shares, Earnings per share EPS = 5000/1000 = $5

And Stock price = P/E x EPS = 15 x 5 = $75

Now, if the sales increases by 20% in the next year, and if the profit margin improves to 7% from 5%. Then,

Net Sales = 100K x 1.20 = 120,000
Net Income = 120,000 x 7% = $8,400
EPS = 8400/1000 = 8.4

Assuming that the market valuation remained the same, and hence the same P/E held on for the next year, stock price = 15 x 8.4 = $126

Did you see how the stock price jumped from $75 to $126, that is a whopping 68% in one year! Now you know what has to go up before the stock price goes upwards.

A classic growth stock can go up when its sales increases or profit margin increases. Now for the same scenario, say if we had a bull run in the year and if P/E had increased to 20 from 15, then lets see what happens to the stock market.

Net Sales = 100K x 1.20 = 120,000
Net Income = 120,000 x 7% = 8,400EPS = 8400/1000 = 8.4
Stock price = 20 x 8.4 = $168

Did you see what effect the bull run had on the stock price; from $75 to $168 !! that is 124% !

-Nidhi