How do stock prices work?

While stock market movements often seem to have to no basis in reality, especially in the short term, there are only three factors driving stock market returns:
1. Dividends: The income generated by stocks adds to total return.
2. Earnings growth: The value of a stock can be viewed as a multiple of its earnings. As long as company earnings grow, even if the price-earnings ratio that investors place on that stock remains unchanged, the value of the stock increases.
3. Change in the Price-Earnings Ratio: Investors may be willing to pay a higher or lower price-earnings ratio tomorrow than today. If the price-earnings ratio increases, that increased valuation will contribute to total return.

We can quantify how each of these three components have contributed to stock market returns over time. For example, over the past approximately 100 years, stocks have delivered about 10% annually with the following breakdown:
Contribution to average annual return
Earnings growth: 5.0%
Change in P-E:0.9%
Dividends:4.5%

Source: PrudentBear.com (Great Site)