Who Are Institutional Investors?

People who trade stocks are broadly defined into one of two groups: institutional investors and individual investors. Institutional investors are the professionals who manage the trillions of dollars invested in mutual funds, pension plans, hedge funds, etc. Individual investors, also referred to as "retail investors," are people who independently invest for their own private accounts.

Institutional investors have a considerably greater ability to influence prices than individual investors. The reason is that institutional investors come to the market with millions of dollars to trade and often buy and sell tens of thousands of shares of a single stock over the course of a trading day. This financial muscle has a material impact on the movement and direction of stock prices.

As an individual investor, you can benefit from the power of institutional investors to increase your investment returns. In order to do this, it is important to understand what motivates institutional investors' buy/sell decisions.

Stock Valuation Models

Most institutional investors attended prestigious business schools where they were taught a number of financial models. Many of these models are used to calculate the fair value of a company, and of its shares. Almost without exception, these valuation models focus on earnings generated by these companies historically and into the future. The only way to run these models based upon future earnings is through the use of earnings estimates. On the simplest level, it can be understood that if you raise the earnings estimates used in the model (input), then it will create a higher fair value for the company and its stock (output).

For example, an analyst could determine that a stock is worth a multiple of 20 times next year's earnings (a P/E of 20). If his current estimate calls for earnings of $1 per share, he would recommend buying the stock for any price below $20 (20 x $1 = $20). If the analyst changes his forecast and believes the company will instead earn $1.10 per share, he would then recommend buying the stock for any price below $22 ($20 x $1.10 = $22). As you can see, an increase in the earnings estimates can translate into a higher price for the stock. Thus, it is imperative to learn more about earnings estimates.

Next: Where Do Earnings Estimates Come From?

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