What Determines Stock Prices?
Have you ever wondered why stock prices jump around the way they do? And why they sometimes seem to change at random? While it may seem random, there are actually quite a few factors that determine stock prices.
Why stock prices change
There are three major categories of factors which influence stock prices.
- Supply and demand
- Business fundamentals
- Economic and other external factors
Factors that determine stock prices
Supply and demand
Perhaps the most influential factor on a stock price is supply and demand. If economics is not your forte, don’t worry. In essence, the more popular or attractive a particular stock is, the greater the price people will be willing to pay for it. This is exacerbated even more so as supply becomes limited.
However, the reverse is also true. The less popular and less attractive a particular stock is, the lower the price people will be willing to pay for it. This is exacerbated even more so as supply increases.
For example
For example, let’s say you’re running a lemonade stand. You’re lucky enough to be selling some delicious, attractive cups of lemonade for 25 cents a cup. Your neighbors take note and start lining up to make a purchase. As the line gets longer and your pile of lemons gets smaller, people start murmuring about whether or not there will be enough left by the time they’re at the front of the line.
So instead of waiting, they decide to try to jump the line and offer you 50 cents. As attraction and popularity grows, you have the ability to demand a higher price for your lemonade. Then the bidding war really starts and you’re able to charge upwards of $2 per cup by the end of it.
Each new price you and your buyer agree upon becomes the new selling price of your lemonade. This is the same process that occurs in the stock market. Each time a new buyer and seller come to a trade agreement, a new stock price is set. So, you can imagine that prices can change swiftly with particularly popular stocks.
Business fundamentals
Stock prices also fluctuate as a matter of opinion. Investors make trading choices based on their opinion of a company’s ability to generate future earnings. While some of those opinions may be a result of a gut feeling, many of them are influenced by analysis of a company’s business fundamentals.
Price to earnings ratio
One common analysis used by investors and analysts is the price to earnings ratio, or p/e ratio. It’s a metric that can be used to assess whether a stock price is reasonable given a company’s underlying earnings. Publicly traded companies must legally and regularly report their financial statements with the Securities and Exchange Commission (SEC). Most of those companies report their earnings quarterly. How well these reports align with investor expectations can have a drastic impact on stock prices.
Remember, the general goal of most of us investors is to invest our money in companies that we can expect to be successful in the future. Whether we reap the benefits through dividends or increased stock prices, we expect a return on our investment. So, if a company’s earnings – an indicator of their ability to succeed now and in the future – aren’t supportive of a stock price (in either direction), that will likely influence a price change.
Economic and other external factors
Beyond supply, demand, and business fundamentals, there are other factors outside of a company’s control which may influence their stock price. Below are some of the more common economic and external factors that can determine stock prices.
Health of the industry
A company’s stock price can also be susceptible to guilt by association. For example, a single company could be in the greatest of financial health. But, if they are a part of a dying industry, they will likely suffer from lower stock prices based upon the influence of the industry.
Of course, there are exceptions to this – it is not a hard and fast rule. Many people may not have expected the success of Cirque du Soleil given the fact that the circus industry was in severe decline, but they were able to reinvent what a circus could be.
Investment alternatives
Another factor which can influence stock prices is the availability of other good investment opportunities. This is closely related to the fundamentals of supply and demand. If supply drops, price will follow. And if there are other, more attractive investment options such as real estate, bonds, etc. then stock prices may decrease as a result.
The opposite is also true. If there are fewer other good investment options, demand may increase for stocks and therefore influence an upward trend of prices.
News
Whether business related or not, and good or bad, news stories about a company can contribute to major stock price swings.
In 2017, Uber suffered a stock price decline of 15% due to multiple CEO scandals and bad news headlines.
In 2018 when Facebook’s CEO testified in Congress regarding the company’s data sharing with third party vendors, their stock plummeted by 40% from its peak.
In 2020, Tesla’s stock surged by 12% in premarket trading after an announcement that the company would be added to the S&P 500.
What does stock price mean for a company?
Investors care about stock prices, and so do the companies who issue the stocks.
A company’s total worth, i.e. market capitalization (or market cap for short) is determined by the number of shares outstanding multiplied by the share price. So, let’s say a company has 50,000 shares outstanding and the share price is $11. The company’s total worth (or market cap) would be $550,000.
There are three major classifications of capitalization based on size – small, mid, and large. Small cap companies have a capitalization between $300 million and $2 billion. Mid-cap companies have a capitalization between $2 billion and $10 billion. Large cap companies have a capitalization of greater than $10 billion.
So the price of a company’s stock is relative and proportionate to their entire valuation. A higher stock price contributes to a higher market capitalization and a lower stock price contributes to a lower market capitalization.
A note of caution
It’s important to note that while we often talk about a company’s total worth (value) and market capitalization as being interchangeable, there are many cases in which a stock price may be over or undervalued. The market price of a stock isn’t necessarily indicative of how much it’s actually worth, but instead how much the market is willing to pay for it.
Public Perception
In the eyes of the public, analysts, and investors, stock prices are a metric that can help gauge the overall financial health and future profitability of a company. It can have a major influence on a company’s reputation.
High stock prices
So, with that logic, a high stock price is generally a good thing for a company. Afterall, a high stock price means the company has a higher total worth. However, a stock price that is too high can be problematic.
Overvaluation
Stocks can sometimes become overvalued. Essentially that means their price is too high compared to the earnings the company is making. If a company’s stock price is deemed overvalued, investors and analysts will expect stock prices to drop. That can put companies in a dangerous spot if investors begin to short the stock (i.e. bet that the price will decline).
Low stock prices
Low stock prices are not always a bad thing. For example, two companies may have the exact same market capitalization but have a different number of shares outstanding. Because of that, their share price would differ but would not necessarily mean one company is more valuable than the other.
Let’s say both company A and company B have a market capitalization of $1 million dollars. Company A has 1000 shares outstanding. That means the share price would be $1 million market cap/1000 shares = $1000 per share. On the other hand, Company B has 10,000 shares outstanding, so their share price would be $1 million market cap/10,000 shares = $100 per share.
Company buyback
If, for whatever reason, a company believes their stock may be undervalued, they may opt to perform a buyback (i.e. purchase their own shares). There are a number of reasons why a company may buy back its own stock. A common reason, though, is when a company believes their stock price is lower than it should be. In that case, the company can hold onto its own stock until it feels the market has corrected and then re-release them for sale at a better price.
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