Stock Market Basics – What Causes Prices To Change?

Supply and demand is the primary reason for stock prices to change. If there are more people who are willing to hold onto their shares, the share price will move up as buyers will have to offer a higher price to entice sellers to trade their shares. On the other hand, if there are more people who want to sell, sellers may find themselves tripping over each other trying to get their shares traded, often moving the price lower.

Supply and demand is an easy concept to understand. What is more difficult to understand is the motivation behind it all.

For every shareholder, there is a separate opinion about what the true value of a stock should be. When news is released, those opinions either change or are reinforced. What is usually taken as good news one moment could be perceived as less than perfect news by someone else. So if a company releases news on how great a quarter they had, and say that next quarter will be 20% higher, the news will be interpreted one of two ways. It may be interpreted as the next quarter, although continuing the growth trend, will not be as good as expected, since the expectations for growth were forecasted at 30%. This would have people heading for the doors. On the other hand, those looking for a growth story may decide to add to their stake.

The value of a company is not based on its share price alone. While it is tempting to suggest that a stock trading at $50 is 10x larger than a company trading at $5, its important to remember what the value of the company is its market capitalization. If the $50 company has 1 000 000 shares out standing, its market cap it $50 000 000. Lets say that $5 company has 10 million shares outstanding. It will have the exact same market cap as its $50 counterpart. The price of a stock reflects only what the perceived future value is of the company. If you buy a stock at $10, you’re not buying it because you perceive the future value to be $10, rather, you believe that in a certain amount of time, it will be worth more. The seller you bought the stock from is predicting the share price will be lower, so he’s getting out while he can. One of you will be right.

So what determines the share price more than anything else?

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, they aren’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 dot-com 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 all 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 P/E ratio, while others are extremely complicated and obscure with names like Chaikin Oscillator or Moving Average Convergence Divergence (MACD).

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 stocks will change in price 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 as a certainty is that stocks are volatile and can change in price extremely rapidly.

The important things to grasp about this subject are the following:

At the most fundamental level, supply and demand in the market determine stock price.

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.

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.

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.

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