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.
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.
