The price of a stock can be viewed as the value of an infinite stream of constant earnings plus the value of its growth opportunities, the latter of which is determined by what the company earns on its reinvested earnings in relation to the rate that its shareholders require to invest in the stock.
When companies generate earnings, they have two choices of what to do with the funds. They can pay dividends or reinvest the funds back into new projects. When companies are able to reinvest at a rate higher than required by investors, the stock price will reflect this value and be higher because of it. Conversely, if companies reinvest earnings at lower than the rate required by their stockholders, the stock price will reflect this as well and will be lower than it would be if the companies stopped investing these funds at inadequate returns.
The price of a stock can be thought of as consisting of two values: the value of an infinite stream of constant earnings and the value of an infinite stream representing the growth opportunities of the company. The latter will be positive if earnings are reinvested at higher than the stockholders’ required rate and negative if earnings are reinvested at lower than the stockholders’ required rate.
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Last updated: January 9, 2011