Do budgets affect stocks? You bet, they do

 

The value of a share primarily depends on the fortunes of a company. If the worth of the company appreciates, so does the value of each share of that company. When the stockmarkets value a company, or in effect its share, they mainly look at the future earnings potential of the company.

 

One popular financial model used by stock analysts is the discounted cash flow model, which aims to assign a value for a company based on the present value of all future cash flows arising from the company. If the present value of future cash flows is greater than the current price of a share, it makes sense to invest in that share, and vice-versa.

 

But estimates of future cash flows keep changing with almost every new bit of information that hits the markets.

 

This is why share prices change when new information pertaining to a particular company, or a sector, or even the economy, comes out. Advocates of the “random walk theory” say that stock prices react to information that becomes known at random, and that, because of the randomness of the information, prices themselves change as randomly as the path of a wandering person’s walk.

 

Since the share price reflects the value of a company, factors affecting the company’s future prospects and financial health, such as new competition, technological advancements and product innovation would affect share prices. For example, Dr Reddy’s announced a deal with American drug maker, Merck this week, which could possibly result in a jump in its earnings in financial year 2007. When this information hit the markets on Wednesday, the Dr Reddy’s share price jumped by over 5%.

 

While this was an example of information that was specific to a particular company, there are some other factors that affect all stock prices in general. These factors, which are normally referred to as market-specific factors, would include events relating to the country’s economy, for instance, or the country’s political environment. The Union budget, in that sense, is a unique event, which could affect not only specific stocks or shares within specific industries, but also the market as a whole.

 

Last year’s budget was hailed by the markets because it cut taxes, had increased allocations for infrastructure projects, and gave signals that the growth momentum in the economy would be maintained. The Sensex rose 144 points on the day the budget was announced. But a look at the stock-specific movement on that day shows that while some stocks gained, others declined. Sugar stocks, for instance were among the highest gainers, thanks to a plethora of sops announced by the finance minister.

 

Similarly, tyre stocks gained because of a cut in excise duty on tyres. The gains in these shares, again, were because future earnings prospects looked better after the budget sops were announced. Shares of textile companies and paper companies weren’t as lucky, since the budget hardly had any big announcements in store for these sectors.

 

In some cases, where sops are removed or phased out (like the government had done a few years ago for IT companies), or taxation is increased, share prices could fall rather sharply.