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Stock prices change every day as a result of 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
wanted to sell a stock than buy it, there would be greater
supply than demand, and the price would fall.
Understanding supply and demand is 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.
Don't equate a company's value with the 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
million shares outstanding has a lesser value than a company
that trades at $50 that has 5 million shares outstanding ($100 x
1 million = $100 million while $50 x 5 million = $250 million).
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, it
isn't going to stay in business. Public companies are required
to report their earnings four times a year (once each quarter).
Wall Street watches with rabid attention at these times, which
are referred to as earnings seasons. The reason behind this is
that analysts base their future value of a company on their
earnings projection. 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 (which, in turn, changes its price). It would be
a rather simple world if this were the case! During the dotcom
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, and most internet companies saw their
values shrink to a fraction of their highs. Still, the fact that
prices did move that much demonstrates that there are factors
other than current earnings that influence stocks. Investors
have developed literally hundreds of these variables, ratios and
indicators. Some you may have already heard of, such as the
price/earnings ratio, while others are extremely complicated and
obscure with names like Chaikin oscillator or moving average
convergence divergence.
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 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.
The only thing we do know is
that stocks are volatile and can change in price extremely
rapidly.
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