What causes prices to change: stock prices change
everyday by market forces. By this we mean that share prices change because of
supply and demand. Any single time, if more people want to buy a stock (demand)
than sell it (supply), then the price moves up. Conversely, if more people want
to sell a stock than buy it, which is a greater supply than demand, then the
price falls.
Understanding supply and demand is pretty much 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. The
company's value is different than its 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 1,000,000 shares outstanding ($100 x 1,000,000 = $100,000,000)has a lesser
value than a company that trades at $50 but has 5,000,000 shares outstanding
($50 x 5,000,000 = $250,000,000). 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, they aren't going to stay in
business. Public companies are required to report their earnings four times a
year. Many analysts forecast earning per share four times a year. 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 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, In fact they are corrected by market value. There are factors
other than current earnings that influence stocks. Investors have developed
literally hundreds of these variables, ratios and indicators.
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:
1. At the most fundamental level, supply and demand
in the market determine stock price.
2. Price times the number of shares outstanding (market
capitalization) is the value of a company. Who is the market leader in terms of
growth and has most relative strength and profit margin.
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.
The Bulls, the Bears, and the Farm: On Wall Street,
the bulls and bears are in a constant struggle. If you haven't heard of these
terms already, you undoubtedly will as you begin invest. The Bulls: a bull
market is when everything in the economy is great, people are finding jobs, GDP
is growing and stocks are rising. Things are just plain rosy, picking stocks
during a bull market is easier because everything is going up. Bull markets
can't last forever though, and sometimes they can lead to dangerous situations
if stocks become overvalued. If a person is optimistic, believing that stocks
will go up, he or she is called a bull and said to have a bullish outlook. The
Bears: a bear market is when the economy is bad, recession is looming, and
stock prices are falling.
