Understanding why stock prices rise is the first step to becoming a successful investor. While many see it simply as "buyers outnumbering sellers," in the long run, what determines the price is the value the company creates. So, what exactly is this value? Let's start by answering a fundamental question:

What are we really buying when we buy stocks?

For a newcomer to the stock market, buying stock might seem like becoming a part of a logo, believing in a vision, or being part of a popular story. But beyond this emotional approach lies a financial reality. When you buy a stock, you are actually buying the "Free Cash Flow" that the company will generate in the future.

Why free cash flow and not net profit or revenue? Because free cash flow is the net cash remaining after a company deducts all its expenses (CapEx) needed to maintain its operations and continue its growth. The "real" value of a publicly traded company—that is, the money left for its shareholders—is this cash.

As an investor, the cash flow you purchase returns to you in three main ways:

Dividend Payments: The company deposits a portion of its earnings directly into your bank account as cash.

Share Buybacks: The company buys back its own shares from the market, effectively eliminating them. This means your share of the pie grows without you having to do anything.

Balance Sheet: Even if the company doesn't distribute the money, this cash increases the "Cash and Cash Equivalents" item on the balance sheet. As long as the company holds its earnings in a bank account, regardless of whether it distributes dividends or conducts buybacks, until it ceases operations, you are a partial owner of that money. This accumulated cash is included in the company's market cap.

How Much is Future Money Worth Today?

Let's make a deal. I will give you $1 every year forever. How much would you pay me today for this deal? First, what do we do here? We choose a discount rate and discount the future money to the present day. So, as time progresses, the present value of $1 in the future decreases slightly for us. We use the NPV (Net Present Value) function in Excel for this calculation. However, if you want to do it manually, for example, to find the value of $1 in 5 years, the formula you would use is $1/(1 + discount rate)^5.

The Effect of Inflation and Time

If we assume inflation is 3% annually, the total present value of $1 coming each year indefinitely would be $33.33. The main reason for this is that as time progresses, future income becomes meaningless compared to today's purchasing power.

To better understand this, let's look at the term. If we were to do this simulation with a term of only 100 years instead of infinity, the value of the agreement would be $31.65. So, the total present value of the remaining 7875 years (or infinity) after the 100th year, adjusted for inflation, would be only $1.68.

Opportunity Cost and Risk-Free Return

Now let's add opportunity cost into the equation. Here we are basing our calculations on 10-year US Treasury bonds, which are considered by most investors to offer a "risk-free return." This rate is currently at 4.227%. If we were to consider making this deal instead of investing our money in this risk-free option, we would discount the future value of our deal by this rate. In this case, the present value of our deal would drop to $23.66.

Stock Market Risk and Cost of Capital (WACC)

The risk of investing in a stock on the stock market is, of course, much higher than the risk of lending to the government. When companies run into trouble or go bankrupt, stock market investors are always the last to get a share of the money in the treasury. While there are different ways to calculate this risk, most investors use a method called WACC (Weighted Average Cost of Capital). The calculation can be summarized in its simplest form as follows:

Discount Rate = Risk-Free Interest Rate (10-year bond) + Equity Risk Premium + Company-Specific Risk

This calculation is a much simpler and more understandable version of the complex WACC (Weighted Average Cost of Capital) formula used in corporate finance. Essentially, we are gathering the building blocks of investment. We are looking for an answer to the question "what percentage return should this investment give me?" by adding the general risk of being a stock market investor, and then the specific risks of that company, to the return we can earn with almost no risk (bond).

The company and country-specific risks here can be calculated via CDS (Credit Default Swap). Furthermore, the fact that companies have their own bonds and that these are examined in detail by credit rating agencies makes the WACC calculation more reliable. This rate generally varies between 8% and 12% depending on the company's structure. However, it can vary greatly depending on the company and the economic climate.

In conclusion, if we consider the risk of this $1 deal as if it were a company on the stock exchange, with a 9% discount, the present value of this infinite cash flow would be only $11.11. Reversing this, we can clearly see how P/E (Price/Earnings) ratios are shaped on the stock exchange. The fair value of a low- to medium-risk company that will not experience future growth but will continue its operations for a long time can be calculated at around 10-12 P/E.

The same logic explains why the average company on the stock exchange is generally priced at 16 P/E, because when we add an average growth rate of approximately 2.75%, we mathematically arrive at this price level. Looking at 10-year US Treasury bonds, reversing the calculation, we get a P/E ratio of approximately 23.66 from a yield of 4.227%.

In fact, we can view stocks as a version of the yield offered by bonds with increased risk. This is because we can also read stocks as a yield through P/E ratios. If a company has no future growth potential and its current Earnings Yield is the same as the 4.227% offered by a bond, there's no rational reason to invest in that company. After all, why take on a company's commercial risk instead of a government guarantee for the same rate of return?

Now let's use the same discount calculation to compare three companies with the same risk profiles but different growth stories. These scenarios will help us understand the mathematical truth behind why a stock appears "expensive" or "cheap."

Company A: Baseline Scenario

In our first example, let's assume a company with current free cash flow of $100. This company will grow at 10% annually until 2030, after which it will mature and continue on its path with long-term economic growth (3%). Using a 9% discount, the fair present value of this company is $2211.74. Assuming free cash flow equals earnings, the fair P/E ratio the market would assign to this company is 22.12.

Company B: The Power of Growth Duration

Our second company starts with the same cash flow, but its growth rate is only 8%, not 10%. However, this company has a difference: it can sustain its growth until 2035, not 2030. Assuming the same risk as Company A, despite its slower growth, this company's present value reaches $2400.39. This means the market is pricing this company at a higher multiple, a P/E ratio of 24. This shows us that the sustainability of growth over a longer period is more critical in pricing than the growth rate itself.

Company C: Value Trap and Terminal Value

Our third company grows at a high rate of 20% annually for 10 years. However, by 2035, the company goes bankrupt or its business model becomes completely obsolete, meaning its terminal value is zero. In this case, although the current P/E ratio appears much lower than the others (17.09), this company actually becomes the worst investment choice.

This is precisely why companies like $PLTR and $FICO are currently priced at very high multiples. If a company promises sustainable and high-rate growth in the future, its value cannot be described solely by current multiples. Similarly, for companies like $ADBE or $NVO, when the terminal value expectation decreases, even if current growth continues, a low P/E ratio becomes largely irrelevant.

Generally, when a valuation is made, 60-80% of the company's total value comes from the terminal value, that is, the assumption of infinite growth starting 5-10 years from now. If the stock market believes that a company will not survive in its terminal phase or will lose its competitiveness, it will not value that company at high multiples, regardless of how high its current profits or growth are. The real driving force behind stock price movements is the change in these future predictions, regardless of whether everything looks good or bad today, due to news or earnings reports.

Similarly, just as future growth expectations and the sustainability of that growth directly affect the share price, any change in the risk profile associated with that growth can rapidly pull the present value up or down through the discount rate. In other words, the market looks not only at "how much it will grow," but also at "how safe" that growth is. As risk perception increases, the discount rate rises, mathematically suppressing the share price.

Therefore, a company that consistently meets expectations can be priced at higher multiples than companies whose expectations fluctuate wildly (far exceeding or falling short). This is because as long as the company meets expectations, that future free cash flow becomes a reality over time. In other words, as the date of the cash flow's realization approaches, the pressure on the discount rate decreases, and that money begins to be priced at its full, "undiscounted" value. This is one of the fundamental reasons why healthy company shares naturally rise over time.

In conclusion, the answer to the question "Why does a stock rise?" can be summarized in three main points:

A stock experiences a natural increase in value over time because the company fulfills its promises. Future cash flow increases in value as it approaches the present.

If the company shows growth exceeding expectations, this creates a snowball effect. Investors not only celebrate today's performance but also revise their future cash flow expectations upwards.

Conversely, if the company fails to meet expectations, this creates a negative snowball effect. Future cash flow forecasts are lowered, and the stock price rapidly depreciates.

Why Exceeding Expectations Isn't Always Enough?

We see that some companies' stock prices fall even when they exceed market expectations in terms of revenue and earnings. The secret to this lies in this pattern. If investors sense a slowdown, or the possibility of one, in a significant growth area, even if the company's profits are high, this leads them to lower all future cash flow expectations.

Because a very large portion of a company's value comes from future cash flows, a small downward revision to that distant future growth rate could cause a massive drop in today's share price. In other words, the stock market is more concerned with what you will continue to earn tomorrow than what you earn today.

All calculations, models, and company examples shared in this article are purely for educational purposes and are designed to increase financial literacy. The information presented here does not constitute investment advice, buy/sell recommendations, or professional financial counseling. Every investor has a different risk tolerance and financial goals, so it is strongly recommended that you conduct your own research or consult a qualified investment advisor before making investment decisions. Past performance is not a guarantee of future results.