05 - Stock Basics: What Causes Prices To Change?

Stock prices are changed everyday by 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 want to sell a stock, there would be more supply than demand and the price would start to fall.

Understanding supply and demand is easy. What is more difficult is understanding what makes people like a stock and what makes people dislike a 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 shows what investors feel a company is worth. Don't confuse what a company is worth with the stock price. The value of a company is its market capitalization, which is the stock price times the number of shares outstanding. For example, a company that trades at $100 per share and has 1,000,000 shares outstanding is worth less that a company that trades at $50 but has 5,000,000 shares outstanding. ($100 x 1,000,000 = $100,000,000 while $50 x 5,000,000 = $250,000,000). To further complicated things, the price of a stock doesn't just reflect what a company is worth currently, it takes into account the growth that investors expect in the future.

The most important indicator of the worth of a company is 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 release earnings 4 times a year (once each quarter). Wall Street watches with rabid attention at this time that is referred to as earnings season. The reason behind this is because analysts base their future value of a company on their earnings projection. If a company's results surprise (are better than expected), the 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 price of a stock. It would be a rather simple world if this were the case! A perfect example of this was the dot-com bubble. Dozens of Internet companies rose to have market capitalizations in the billions of dollars without ever of making the smallest profit. As we all know, these valuations did not hold and most all Internet companies saw their values shrink to fractions of their highs. Still, the fact that prices did move this much demonstrates that there are other factors than earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may of 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:
1. Supply and demand in the market determine stock price.
2. Price times the number of shares (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.
3. Earnings are theoretically what makes a company increase its value, but there are other indicators which investors use to predict stock price.
4. There is no consensus as to why stock prices move the way they do.