What Causes Stock Prices To

Change

Every day we see stock prices changing but what is the reason for thisstock price movement? Stock prices change every day as a result ofmarket forces. This in its most simple form means that share prices changebecause of supply and demand. If more people prefer buying a stock(demand) than selling it (supply), then the price will move up. Conversely,if more people prefer selling a stock than buying it, there would be greatersupply than demand, and the price would fall.

But before understanding what makes movement in the price it wouldbe better to understand what price is. Financial theorists define stockprice as the present value of all future earnings expected for thecompany, divided by its number of shares outstanding. What thismeans is that the earning capacity of the company is what that definesits price. Often, companies can get significant value out of a relativelysmall investment in assets because the ability for those assets to makemoney is significant.

Even companies that lose money today can have a high share pricebecause price is based on the future earnings of the company. Noenterprise is in business to lose money, so the expectation is thatevery business will make money some day. So long as there is thepotential for future revenue streams to shareholders, there will be aprice that someone is willing to pay for the shares. Thus the earningsthat a company could make in the future, the growth that thecompany could realize and the time to the realization of these goalsare all factors which affect the price of a stock.

In a theoretical sense, any time someone buys the shares of acompany in the market, they are effectively stating that theybelieve the shares of the company are undervalued. The fact thatthey are buying implies a belief and expectation that the shareswill increase in value in the future. At the same time, the personwho is selling the shares is expressing the opposite belief. Byselling, they imply that the stock is overvalued and theexpectation that the stock will go lower in the future. In thisway, the stock market is forum for debate on what the value of thecompany and its shares is.

So, why do stock prices change? The bestanswer is that nobody really knows forsure. Some believe that it isn't possible topredict how stock prices will changewhile some believe that it cannot bepredicted when the price will change butwe can identify the factors which cancause potential price movements.

There are four major factors that cancause movements in stock price:

New information:

Information is the key, as it gives the market a reason to value a stock at aparticular price level. The market will price a stock based on all informationthat the public is aware of. As new information comes into the public realm,the market will adjust prices up or down based on how the market perceivesthe information will affect the future earnings capacity of the company.

Uncertainty:

What a company will make in the future is far from certain. Forthis reason, we should expect stocks to bounce around a littlebit because of the nervousness of the market about the futureof the company. The uncertain future of the company will bringsome volatility in share prices even during a period in whichthere is no new information.

Psychological Factors:

Humans minds are behind the trading activity in the stock market. This meansthat human characteristics are also factors in how the share prices will move.Understanding human psychology is extremely valuable when evaluatinginvestment opportunities because human psychology creates and accentuatesmany of the opportunities that investors can capitalize on.

Two major human behaviors which affect prices are:

• Fear:Fear motivated by negative information can cause everyone to rush for the exit door at once and take astock, or entire markets, dramatically lower very quickly. Much of the selling pressure that prevailsduring market crashes is out of fear and not on a rational thought process based on information.

• Greed:Greed often causes stocks to go higher than their true value. New information can cause frenzy in themarket that makes investors lose sight of rational valuation and simply buy the stock for fear of beingleft behind. This phenomenon is the basis for some great speculative bubbles that we have seen inhistory.

Fear and greed present incorrect valuations in the market that can exist for relatively short periods oftime but long enough for smart investors to capitalize on. Emotion in the market can be viewed as anamplifier for new information. It can make moves more extreme than they should be.

Supply and Demand:

Supply and demand can take the short-term balance out of thestock market and present opportunities for investors who have thepatience to see that balance restored.

Some important things to grasp about stock prices are the following:

•At the most fundamental level, supply and demand in the market determines stockprice.

• Theoretically, earnings are what affect investors' valuation of a company, but there areother indicators that investors use to predict stock price. Remember, it is investors'sentiments, attitudes and expectations that ultimately affect stock prices.

• There are many theories that try to explain the way stock prices move the way they do.Unfortunately, there is no one theory that can explain everything.

In short it can be said that price reflects all theinformation that is known about a company and theirability to make money in the future. As informationabout a company's prospects is made public, prices willchange. Uncertainty of the future can bring addedvolatility while psychological factors can amplify theeffect of new information. Finally, supply and demandconsiderations can cause fluctuations not motivated bynew information. Understanding why prices change isessential for success in the stock market.

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