The recent volatility of the stock market provides a compelling reason to examine the fundamental factors affecting security prices. The U.S. stock market has rewarded investors generously since the beginning of the 1980s. Young financial professionals have only experienced the bull market. Many analysts have declared the business cycle dead. Globalization and increased technological innovation are factors identified as changing financial fundamentals.
Stocks are financial assets that represent an ownership claim on businesses.
Like all financial assets, stocks derive their value from the cash flows that are generated by the underlying real assets. As Adam Smith noted in the Wealth of Nations over 200 years ago, an increase in financial assets alone does not improve the well being a nation. The standard of living increases when the productive potential of an economy increases, not when the value of financial assets increases. Stock prices fundamentally depend upon the value of their expected cash flows. An increase in earnings or the growth rate in earnings results in an increase in stock prices.