Why do Stock Prices Change?
Stock prices change every day as a result of market forces. By
this we mean that share prices change because of supply and demand. If more
people want to buy a stock (demand) than sell it (supply), then the price moves
up. Conversely, if more people wanted to sell a stock than buy it, there would
be greater supply than demand, and the price would fall.
The Graph here shows how the price of a stock has risen and fallon throughout
the year. If the stock goes down, the price goes down but if it goes up the price goes up.
Understanding supply and demand is easy. What is difficult to
comprehend is what makes people like a particular stock and dislike another
stock. This comes down to figuring out what news is positive for a company and
what news is negative. There are many answers to this problem and just about
any investor you ask has their own ideas and strategies.
That being said, the principal theory is that the price movement
of a stock indicates what investors feel a company is worth. Don't equate a
company's value with the stock price. The value of a company is its market
capitalization, which is the stock price multiplied by the number of shares
outstanding. For example, a company that trades at $100 per share and has 1
million shares outstanding has a lesser value than a company that trades at $50
that has 5 million shares outstanding ($100 x 1 million = $100 million while
$50 x 5 million = $250 million). To further complicate things, the price of a
stock doesn't only reflect a company's current value, it also reflects the
growth that investors expect in the future.
The most important factor that affects the value of a company is
its earnings. Earnings are the profit a company makes, and in the long run no
company can survive without them. It makes sense when you think about it. If a
company never makes money, it isn't going to stay in business. Public companies
are required to report their earnings four times a year (once each quarter).
Wall Street watches with rabid attention at these times, which are referred to
as earnings seasons. The reason behind this is that analysts base their future
value of a company on their earnings projection. If a company's results surprise
(are better than expected), the price jumps up. If a company's results
disappoint (are worse than expected), then the price will fall.
Of course, it's not just earnings that can change the sentiment
towards a stock (which, in turn, changes its price). It would be a rather simple
world if this were the case! During the dotcom bubble, for example, dozens of
internet companies rose to have market capitalizations in the billions of
dollars without ever making even the smallest profit. As we all know, these
valuations did not hold, and most internet companies saw their values shrink to
a fraction of their highs. Still, the fact that prices did move that much
demonstrates that there are factors other than current earnings that influence
stocks. Investors have developed literally hundreds of these variables, ratios
and indicators. Some you may have already heard of, such as the price/earnings
ratio, while others are extremely complicated and obscure with names like
Chaikin oscillator or moving average convergence divergence.
So, why do stock prices change? The best answer is that nobody
really knows for sure. Some believe that it isn't possible to predict how stock
prices will change, while others think that by drawing charts and looking at
past price movements, you can determine when to buy and sell. The only thing we
do know is that stocks are volatile and can change in price extremely rapidly.
The important things to grasp about this subject are the
following:
1. At the most fundamental level, supply and demand in the market
determines stock price.
2. Price times the number of shares outstanding (market
capitalization) is the value of a company. Comparing just the share price of
two companies is meaningless.
3. Theoretically, earnings are what affect investors' valuation
of a company, but there are other indicators that investors use to predict stock
price. Remember, it is investors' sentiments, attitudes and expectations that
ultimately affect stock prices.
4. There are many theories that try to explain the way stock
prices move the way they do. Unfortunately, there is no one theory that can
explain everything.