Share price appreciation and dividends are the primary drivers of returns for shareholders. In an earlier article, I discussed how stock prices are a function of future cash flows to the investor. In much the same light, investors sometimes value stocks based on multiples to earnings or revenue. This is because revenue and earnings is what ultimately drives cash flow to shareholders. In this article, I discuss how business fundamentals and valuation growth may drive capital appreciation.

The two key factors

The equation below shows the relationship between share price appreciation, valuation, and a company’s growth. Share price appreciation = Earnings/revenue growth X Price-to-earnings/revenue multiple expansion Put simply, a company’s share price is driven by earnings/revenue growth and changes in the price-to-earnings/revenue multiple. Increases in the price-to-revenue/earnings multiples are usually driven by a better outlook, new information, or market participants appreciating a company’s future prospects.

How to use this information?

As investors, knowing how stock prices rise can help us to pick stocks....