THE BASICS #8: WHY STOCKS GO UP & DOWN
Stocks don’t just “go up”. Stock prices go down too, which can spell trouble for uninformed investors. So let’s make sure you’re not one of those!
Sometimes it’s easier to understand what something is by understanding what it is not:
A stock’s price is NOT arbitrary. Remember, the price is a reflection of the overall value of the company. That “overall value” is called a company’s market capitalization, or mkt cap for short.
Using our cake analogy: If a cake is divided into 10 slices and the price tag on each slice is $10, then added up, the price tag on the whole cake would be $100. 10 slices x $10 per slice = $100 total. Same thing goes for companies!
Market cap = $ per share (price tag) x # of shares (slices)
The stock price of one company CANNOT be directly compared to the stock price of another! This is a common misconception - many people think that a $50 stock is “more expensive” than a $10 stock, and vice versa (a $10 stock is “cheaper”). That is NOT true.
For example, a $10 stock could imply the same market cap as a $50 stock. Back to the cake... If a cake is divided in half (2 slices), and the price tag on each slice is $50, added together, that'd imply that the whole cake is worth $100. Just like the cake divided into 10 slices priced at $10 each!
Or, let’s say the cake is divided into 4 slices with a price tag of $20 per slice. Added together, they imply the whole cake is only worth $80. So even though $20 > $10, in this example, the company whose stock is at $20 is actually worth less than the company whose stock is at $10.
To make things simple for you, I recommend thinking about it like two sliding scales that move in sync:
- When you see a stock’s price go up, that means the company’s market cap is increasing. Investors think the company is worth more than before.
- When you see a stock’s price go down, the company’s market cap is decreasing. Investors think the company is worth less than before.
But what makes someone pay a higher or lower price for a certain stock? Fundamentally, it’s supply and demand. Supply meaning how much stock is available for sale, and demand meaning how many people want to buy it, and how badly they want to own it.
- The higher the “want it, need it, gotta have it” factor, the higher the price someone may be willing to pay.
- Or, if someone really doesn’t want to own a certain stock anymore, their “I’ve gotta get rid of this” feeling may push them to accept a lowball offer.
Aside from that, there are two main factors that really drive stock prices. One is qualitative, rooted in feelings and observations, and the other is quantitative, based on information and calculations.
1) The first factor is called sentiment, sometimes called “animal spirits” by the talking heads on CNBC. Think of it like the mood swings of the market:
- When people are optimistic and believe the economy is growing, that will drive stock prices up.
- Optimistic people are called bulls. When the stock market is rising, we say that people are bullish.
- When people are pessimistic and think the economy is shrinking, that will drive stock prices down.
- Pessimistic people are called bears. When the stock market is dropping, we say that people are bearish.
2) The second factor is financial results.
- Companies report this information every three months (each quarter), and they actually share A LOT of info!
- Many give guidance, or an estimate of how much revenue and profit they expect to make in the next quarter.
- This info can be found on a company’s website, usually under “investor relations”, and by searching for the company on sec.gov.
- Important note: Analysts often come up with their own projections, even when the company has given guidance. Stocks move on these estimates as well.
- Most release their results in April, July, October, and January. Those time frames are called earnings seasons and can be a little hectic for the market. But they can also create great investment opportunities if you’ve done your research.
- If a company's actual results are better than expected, the stock price may go up. This is because the results "surprised” investors and “beat” their expectations.
- If results are worse than expected, the stock price may drop. This is because the company “missed” estimates and “disappointed” investors.
- Both of these scenarios often create a domino effect. This is where supply and demand comes in:
- If results surprise, there may be more people trying to buy shares than are actually available for sale. In this case, demand is greater than supply, which can force buyers to pay a higher price to get their hands on the stock.
- If results disappoint, there may be more people who want to sell their stock than people who actually want to buy it. In this case, supply is greater than demand, which can force sellers to sell their shares at a lower price just to get them off their hands.
On January 28, 2016, Amazon (ticker: AMZN) reported fourth quarter (Q4) results that missed expectations. Investors were disappointed and sold stock. This caused the price to drop from $635.35 per share on 1/28/16 to $482.07 per share by 2/9/16. That's a 24% decline! Any investor who held onto their stock during that time lost 24 cents of every dollar they had invested in AMZN. BUT if they didn't panic and held onto their shares, they've since made their money back and more.
On January 27, 2016, Facebook (ticker: FB) reported Q4 results that beat expectations. Investors were psyched and bought up shares quickly. This caused the price to run up from $94.45 on 1/27/16 to $115.09 on 2/1/16. That's a 22% increase! Anyone who owned stock before they reported earnings made 22 cents on every dollar they had invested in FB. BUT the excitement faded quickly and FB stock dropped back down below the $100 mark a few days later. It has since recovered to over $117 (as of 5/25/16). Investors who held on during the rollercoaster earned that 22% gain back.