Part 1 · Getting comfortable with the economy · Lesson 1
Know the economy and you can see stock prices
Stock prices move on two knobs: 'earnings' and 'the multiple'. The economy shakes both of them.
QToday's question
The company earned more than last year, so why did the stock price fall?
This is the most bewildering moment for new investors. The earnings headlines are good, your stock is in the red, and all you hear is "it's because of interest rates." In this lesson we build up what a stock price is made of, piece by piece, and answer that question.
MAPLearning map for this lesson
We build it up in three steps. At the end of each step, a 'Quick check' lets you test your understanding before moving on.
If you are new, start here. No prior knowledge is needed. If you can multiply and divide, that is enough, and for any term you don't know, tap the dotted underline to see an explanation right away.
- STEP 1 · Basic conceptsStock price and a company's price tag
You will be able to tell the stock price (the price of one share) from the (the price of the whole company), and explain that a company's value ultimately comes from 'earnings'.
- STEP 2 · Understanding the principleStock price = earnings × multiple
You will be able to calculate a stock price directly from EPS and PER, and explain why the multiple differs even for the same earnings.
- STEP 3 · Real-world applicationReading the news through the 2022 market
You will be able to split a real market decline into earnings and multiple, and classify for yourself which knob a news item is shaking.
STEP 1Stock price and a company's price tag
Let's lay the bottom brick first. Once you know what a stock price is the price of, everything else gets much easier.
A stock is a small slice of a company
A joint-stock company divides the ownership of the company into countless slices. One slice is one share, and the price at which one share trades on the market is the . That is why the stock price alone does not tell you what the whole company is worth. The value of the whole company is the price of a slice multiplied by the number of slices. This is called the .
Let's calculate with two imaginary companies.
| Example company | Stock price | Shares outstanding | Market capitalization |
|---|---|---|---|
| Robin Electronics | KRW 20,000 | 10 million shares | KRW 200 billion |
| Sky Bakery | KRW 100,000 | 1 million shares | KRW 100 billion |
An example built with a hypothetical company.
Sky Bakery's stock price is 5 times higher, but Robin Electronics is twice as big as a whole company. So the statement "the stock price is KRW 100,000, so it's an expensive stock" can be wrong. Whether a stock price is expensive or cheap can only be judged together with the 'earnings' you will learn about in the next step.
A company's value ultimately comes from earnings
Why do people pay money for a slice of a company? To share in the the company will make in the future. The more earnings a company has and the longer they are likely to last, the higher the price people pay. This raises a question: does a company with the same earnings always fetch the same price?
Easy analogy · buying a neighborhood bakery
A neighborhood bakery that steadily earns KRW 10 million a year is up for sale. How much would you be willing to pay? The benchmark is a bank deposit. Let's calculate how much you would have to deposit to receive the same KRW 10 million as deposit interest.
| Bank interest rate | Deposit needed for KRW 10 million of interest a year | Feel for the bakery's price |
|---|---|---|
| 1% a year | KRW 1 billion | Even KRW 200–300 million (20–30 times earnings) looks better than a deposit |
| 5% a year | KRW 200 million | Above KRW 200 million, the deposit is the better deal. Once you factor in the risk that the shop does poorly, it falls to the KRW 100 million range. |
The bakery earns exactly the same KRW 10 million, yet the price people are willing to pay varied several-fold with the bank interest rate. The higher the rate, the less attractive 'money to be earned in the future' becomes. The rate used to discount future money into today's value is called the . You will learn about it in detail in Part 3; for now, just keep the feeling that "when interest rates rise, the same earnings are worth less."
This is a simplified example to aid understanding. Actual prices are set by many factors, including growth, risk and taxes.
Quick checkCompany A's stock price is KRW 50,000 and Company B's is KRW 10,000. Which company is bigger?
STEP 2Stock price = earnings × multiple
In STEP 1 we said a company's value comes from earnings. Now let's turn that relationship into a formula per share.
Stock price = earnings (EPS) × multiple (PER)
The stock price is the product of the that one share makes and the the market puts on those earnings. The economy shakes both of these knobs.
EPS: what one share earns in a year
Divide the company's total net income for the year by the number of shares and you get the earnings per share. This is EPS (earnings per share). Suppose Robin Electronics from STEP 1 earned a net income of KRW 20 billion in a year.
- EPSNet income KRW 20 billion ÷ 10 million shares = KRW 2,000
- PERStock price KRW 20,000 ÷ EPS KRW 2,000 = 10x
- Flipped aroundEPS KRW 2,000 × PER 10x = stock price KRW 20,000
A PER of 10x can be read as "if today's earnings continue unchanged, it takes 10 years to earn back the price of the stock." Conversely, calculating 1 ÷ PER gives the ratio of earnings to the stock price. A PER of 10x means 10%, and a PER of 20x means 5%. This is exactly the number we compared with the bank interest rate in the bakery analogy. That is why, when interest rates rise, people demand a higher earnings ratio, that is, a lower PER.
See it as a picture: the area of the rectangle is the stock price
In the rectangle below, the width is earnings (EPS), the height is the multiple (PER), and the area is the stock price. Move the sliders or press the scenario buttons. The dotted line is the starting state.
EPS KRW 1,000 × PER 10.0x = stock price KRW 10,000
Press the 'Like the US in 2022' button. Earnings grew a little, but the multiple shrank a lot, so the area of the whole rectangle (the stock price) actually gets smaller. Which of the two knobs moved more decides the direction of the stock price. We will check this scene again with real numbers in STEP 3.
Why does the multiple swell and shrink?
Earnings are a number a company produces by doing business, so they change relatively slowly. The multiple, on the other hand, carries the calculations and moods of market participants, so it moves much faster. There are three main forces that move the multiple.
When rise, safe investments like deposits and bonds become more attractive, and future earnings are discounted more heavily when converted into today's value. The multiple tends to fall even for the same earnings.
A company expected to grow earnings quickly gets a high multiple relative to its current earnings. When expectations are cut, the multiple falls even if earnings stay the same.
When a lot of money is released into the market () and optimism spreads, multiples swell; when fear grows, they shrink. can't be pinned down by numbers, so it is the most fickle.
Same earnings, different multiples
Suppose three companies all earn the same EPS of KRW 1,000. If growth expectations differ, the multiple the market assigns differs, and the stock prices end up several times apart.
A company with a high multiple also carries high expectations. So when interest rates rise or expectations waver, there is more room for the multiple to shrink. This is why growth stocks are sensitive to interest rates (you will learn more in Lesson 17).
The two knobs the economy shakes
Now let's connect this to the economy. Business conditions, consumption, exports and commodity prices mainly move the earnings knob, while interest rates, investor sentiment and liquidity mainly move the multiple knob.
When business conditions improve and exports grow, a company's revenue and earnings rise. When commodity prices rise, the earnings of companies that sell commodities go up and the earnings of companies that buy and use them go down. Conversely, when interest rates rise, the discount rate goes up and the same earnings get a lower multiple. A single piece of economic news often shakes the two knobs at once, in different directions.
Common misconceptions
- "A low PER always means a cheap stock?"
- No. PER comes out low when the market expects earnings to shrink, or when this year's earnings are one-time earnings, like money from selling land. A low PER often has a reason, so you also need to check whether earnings will continue.
- "If earnings rise, the stock price must rise?"
- No. If the multiple shrinks by more than earnings grow, the stock price falls. Also, if the market had already expected an even bigger rise in earnings, good results can still bring disappointment selling (you will learn this in Lesson 20).
- "The higher the stock price, the more expensive the stock?"
- No. As we saw in STEP 1, a stock price is just the price of one slice. Whether it is expensive is judged by the price relative to earnings, that is, a multiple like PER.
Quick checkIf EPS is KRW 3,000 and the market assigns a PER of 8x, what is the stock price? What if interest rates fall and the PER becomes 10x?
STEP 3The 2022 US market and reading the news
Now let's take apart the real market with the tools we've built. 2022 was the classic year when 'earnings held up but stock prices fell.'
From inflation to stock prices: one year's flow
- First half of 2022Inflation surges
US consumer prices () rose 9.1% from a year earlier in June, the biggest increase in about 40 years.
- March ~ DecemberThe Fed's rapid rate hikes
Starting with its first hike in March, the raised its policy rate from 0–0.25% to 4.25–4.50% by year-end.
- Start of year → end of yearMarket interest rates rise
The US 10-year Treasury yield rose from about 1.5% to 3.88%. In effect, the discount rate went up a lot.
- Year-endMultiple shrinks, index falls
The S&P 500's forward P/E fell from 21.3x to 16.7x, and the index dropped 19.4%.
Breaking it down by numbers
End of 2021 → end of 2022: three numbers for the S&P 500
| End of 2021 | End of 2022 | |
|---|---|---|
| S&P 500 index | 4,766 | 3,840 |
| Forward 12-month P/E | 21.3x | 16.7x |
| Forward 12-month EPS (backed out) | About 224 | About 230 |
| US 10-year yield | About 1.5% | 3.88% |
Sources: S&P 500 closes from FRED and Yahoo Finance (2021.12.31, 2022.12.30); forward P/E from FactSet Earnings Insight (year-end figures in the issues of 2022.2.18 and 2023.2.10); 10-year yield from Yahoo Finance (2022.12.30). Forward EPS is backed out as index ÷ forward P/E.
Split the numbers and the reason becomes visible. The earnings expected over the next year (forward EPS) actually rose about 2.7%. But the multiple the market assigned () shrank about 22%, from 21.3x to 16.7x, and the index fell. Checking with the formula from STEP 2: 1.027 × (16.7 ÷ 21.3) ≈ 0.81, that is, a decline of about 19%. The 2022 decline was not a 'decline where earnings collapsed' but a 'decline where the multiple shrank.'
Two sectors that moved in opposite directions in the same year
Where the earnings knob won
Energy sector about +57%
The surge in oil prices sharply boosted the earnings of refiners and oil companies. The force of rising earnings was far stronger than the force of the shrinking multiple, so it was the only one of the 11 US sectors to rise.
Where the multiple knob weighed things down
Technology sector about −28%
Tech stocks, which had earned high multiples on far-off growth expectations, saw their multiples shrink sharply as rates rose. The decline was large even though earnings did not collapse.
Full-year 2022 returns based on the Energy Select Sector SPDR (XLE) for energy and the Technology Select Sector SPDR (XLK) for technology. Source: Yahoo Finance (2022.12.30).
In practice: sorting news by knob
From now on, when you see economic news, first ask: "Does this news move the earnings knob or the multiple knob?" Let's practice.
| News example | Knob that moves first | How to read it |
|---|---|---|
| "Semiconductor exports jump sharply" | Earnings | Expectations for semiconductor companies' revenue and earnings rise. |
| "US 10-year yield surges" | Multiple | The discount rate rises, so multiples, especially for growth stocks, tend to shrink. |
| "International oil prices spike" | Earnings | Refiners' earnings rise, while earnings of airlines that buy fuel fall. If it stokes inflation, it also affects the multiple through interest rates. |
| "Fed signals rate cut" | Multiple | Expectations that the discount rate will fall tend to lift multiples. |
You can check which sectors current interest rates, exchange rates and oil prices favor on the Macro Map, and the schedule of earnings and economic indicator releases on the Earnings & Economic Indicators Calendar.
It is not always so. In a recession, earnings and multiples can shrink together and cause an even bigger drop, and even when rates rise, the stock price can go up if earnings grow faster. The two knobs are not 'the answer' but a framework for organizing your thinking.
Quick checkWhich of the two knobs does the news "US 10-year Treasury yield surges" shake first? Which gets hurt more, growth stocks or bank stocks?
✓What we learned today
- The stock price is the price of one small slice of the company, and the value of the whole company is market capitalization = stock price × number of shares. A high stock price does not mean a big company.
- Stock price = EPS × PER. EPS is the earnings one share makes, and PER is the multiple the market puts on those earnings.
- The multiple grows and shrinks with interest rates (the discount rate), growth expectations, and investor sentiment and liquidity. When interest rates rise, the multiple tends to fall even for the same earnings.
- In 2022, the S&P 500's forward earnings rose about 2.7%, but its multiple shrank from 21.3x to 16.7x and the index fell 19.4%. It was not a 'decline where earnings collapsed' but a 'decline where the multiple shrank.'
- When you see the news, first ask: "Is this the earnings knob or the multiple knob?" This is the basic question we will use throughout all 43 lessons.
Today you learned that stock prices come from 'earnings'. In the next lesson, we follow the flow of money circulating among households, companies, the government and the rest of the world to see where those earnings come from.
Quiz5-question quiz
Pick an answer and it's graded right away with an explanation.
Q1. A company has a stock price of KRW 20,000 and 5 million shares outstanding. What is its market capitalization?
Market capitalization = stock price × number of shares. KRW 20,000 × 5 million shares = KRW 100 billion.
Q2. If a company's EPS (earnings per share) is KRW 1,000 and the market assigns a PER of 10x, what is the stock price?
Stock price = earnings × multiple. KRW 1,000 × 10 = KRW 10,000.
Q3. When interest rates rise quickly, which of the two knobs is more likely to be shaken hard first?
When interest rates rise, the discount rate used to convert future earnings into today's value grows. So the market assigns a lower multiple to the same earnings. That is what happened in the US market in 2022.
Q4. What is the best reason a stock price can fall even though the company's earnings grew?
The stock price is the product of earnings and the multiple. In 2022, the S&P 500's forward earnings rose about 2.7%, but the multiple shrank about 22%, so the index fell 19.4%.
Q5. A company has a very low PER of 4x. What should you check first?
A low PER often has a reason. If the earnings are one-time earnings, like money from selling land, or the market expects earnings to fall, the PER comes out low. Start by checking whether the earnings will continue.
NextTerms · Next lesson · Related tools
The price at which one share of a stock trades in the market. Over the long run it is set by the earnings the company makes and the multiple (P/E) the market puts on those earnings.
Market capitalizationMarket capitalizationStock price × number of shares issued. The price the market puts on the whole company.
EarningsEarningsThe money a company has left after subtracting cost of sales, expenses, interest and taxes from revenue (net income). It is the most basic factor that determines the stock price.
EPSEarnings Per ShareNet income ÷ number of shares outstanding. The profit one share earned in a year.
P/EPrice-Earnings RatioShare price ÷ EPS. A multiple showing how many times one year's earnings the market pays for a share. It varies greatly with interest rates and investor sentiment.
Forward P/EForward P/EThe current share price divided by expected EPS for the next 12 months. It is the multiple the market puts on future profit.
Interest rateInterest rateThe price of borrowing money. When rates rise, the present value of future earnings falls, which tends to lower stock multiples.
Discount rateDiscount rateThe rate used to convert future money into today's value. It is usually set as an interest rate plus a risk premium. The higher the discount rate, the smaller the present value of future earnings.
Investor sentimentInvestor sentimentWhether investors are optimistic or pessimistic. With the same earnings, better sentiment gives a higher multiple.
LiquidityLiquidityThe amount of money released into the market, or how easily an asset can be converted into cash. When there is plenty of liquidity, asset prices tend to rise.
ValuationValuationThe work of assessing a company's value, or the degree to which a stock price is expensive or cheap relative to earnings and assets. P/E and P/B are the main indicators.
This is educational material and not investment solicitation. There is no guarantee that past relationships will repeat in the future.