Reasons Behind Changes of Stock Prices

Before you should start trading in the stock market, Unifunds advises all traders to understand the factors that affect stock price changes.

Stock prices change every day as a result of market forces. This means share prices change because of supply and demand. If more people wish to purchase a stock (demand) rather than sell it (supply) then the price will increase. On the other hand, if more people wanted to sell a stock than buy it, there would be higher supply than demand, and the price would fall.

Understanding supply and demand is easy. The difficulty is in comprehending what makes people prefer a particular stock to another. This leads to figuring out which news is positive for a company and which news is negative. There are many answers to this problem and any investor you ask has their own ideas and strategies about it.

The principal theory is that the price movement of a stock indicates what investors feel a company is worth. However, it should not be assumed that a company’s value is equated to its stock price. The value of a company lies in its market capitalisation, 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 and has 5 million shares outstanding. The formula is as follows: $100 x 1 million = $100 million while $50 x 5 million = $250 million.

To further complicate things, the price of a stock does not only reflect a company's current value, but also reflects the growth of the company that investors expect in the future.

The most important factor that affects the value of a company is its earnings. Earnings are the profit that a company makes. Public companies are required to report their earnings four times a year, which is once in each quarter. Wall Street watches with rabid attention at these times. The reason behind this is that analysts base the future value of a company on their earnings projection. If a company's results are better than expected, the price will jump up. If a company's results are worse than expected then, understandably, the price will fall.

It's not only earnings that can change the sentiment towards a particular stock. During the dotcom bubble, dozens of Internet companies achieved market capitalisations with billions of dollars without making even the smallest profit.

However, these valuations did not hold and most of the companies saw their values shrink to a fraction of their highs.

Still, the fact that the prices moved that much demonstrates that there are factors aside from current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators.

So, the reasons behind the changes in stock prices are still questionable. 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 stocks. The only thing we do know for certain is that stocks are volatile and can change in price extremely rapidly.

Unifunds would like all investors to grasp the following important facts:

  1. At the most basic level, supply and demand in the market determines stock price.
  2. Price times the number of shares outstanding, or market capitalisation, equals to the value of a company. Comparing just the share price of two companies is meaningless.
  3. Theoretically, earnings are the factor that affects investors' valuation of a company, but there are other indicators that investors use to predict stock price, such as investors' sentiments, attitudes and expectations.
  4. There are many theories that attempt to explain the way stock prices move and fluctuate. Unfortunately, there is no one single theory that can explain everything.