5) Stock Basics: What Causes Stock Prices To Change?

by · August 25, 2010

Stock prices are driven by the law of supply and demand. If the demand is high, i.e., lots of people want to buy stock than sell (supply), then prices go up. If more people want to sell stock than buy it, then prices go down.

While this concept is relatively easy to understand, what makes it difficult to analyze is why people would like one stock from another. It all boils down to what news brings a positive light to a company and news that brings a negative impact. There are various answers to this problem and investors each have their own ideas and strategies.

Price movement of a stock is relative to how investors feel a company is worth but this does not equate to a company’s value with stock price. The company’s value is its market capitalization which is stock price times the number of shares outstanding.

Let’s take this example:

A company that trades at $60 and has 5M shares outstanding has a higher value than a company that trades at $100 but with only 1M shares outstanding ($60 x 5M = 300M while $100 x 1M = 100M).

A company’s value is most importantly affected by its earnings, which is the profit a company makes. Without earnings, no company will be able to survive. Once each quarter, or four times a year, public companies are required to report their earnings. This is referred to as the earnings seasons, which is being watched by Wall Street keenly. This is done so that analysts have a better projection of the future value of a company and their earnings projection. The price jumps up if a company’s results surprise (better than expected) and falls if it disappoints (worse than expected).

Of course, stocks are not only affected by earnings. For example, during the dotcom bubble, lots of internet companies had market capitalizations in billions of dollars without earning anything. Still prices did move that much proving that factors other than current earnings influence stocks. Investors have developed hundreds of these variables, ratios, and indicators like price/earnings ratio, Chaikin Oscillation, or Moving Average Convergence Divergence.

Nobody has a definite answer on why stock prices change. Everyone does know that stocks are volatile in nature. At any time the prices can change in extremes. People have devised ways to determine when to trade by drawing charts and by looking at past price movements of stocks.

The key points to remember about this subject are the following:

1. Stock prices, at the most fundamental level, is determined by supply and demand.
2. The value of a company is not determined by just comparing the share price of two companies. It is through the stock price multiplied by the number of shares outstanding (market capitalization).
3. It is not only by the way of earnings that a company’s stock prices are affected, but also through investor sentiments, attitudes and expectations.
4. Until now nobody has a definite answer on why stock prices move the way they do.

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