Editor’s note: This article was first published in April 2012. The data are from then: Apple at more than $610 a share and worth more than Google and the whole IBEX 35, Inditex at an all-time high, and euro-crisis fears about Greece, Spain and Italy. Apple’s quoted prices predate its later stock splits and are not comparable with current quotes.
A reader from New Jersey asks us:
“Hi, I’d like to know exactly which factors make the price/value of a share go up or down, since people online say it’s because of investors, inflation, debt and net worth. If that’s the case, I’d like to know in detail.”
Stock market investing is governed by supply and demand. The simple explanation is that a share’s price falls when there are more investors selling it than buying it, and rises when there are more shareholders buying than selling. That is the only reason the price moves. Of course, we now need to look at the factors that lead an investor to decide to sell their shares (fear of losses or taking profits) or to buy them (a profitable investment opportunity in the short, medium or long term). Let’s look at them in depth, in simple terms.
1. The value assigned by agencies and analysts
Let’s imagine we’ve bought shares in Gamesa at €3.40. The next day it’s announced that an agency considers the share’s fair value (its target price) to be €3. Many investors will believe they hold a share that is trading above its value, so some would think it’s time to sell before the price falls.
2. The company’s results come in below its profit forecast
If thousands of investors bought into a company with potential, thinking it would close the year with 200 million in profit, and the news then comes out that it made only 90 million, doubts would again arise about the value of the company’s shares. This usually translates into a fall in the share price, as investors sell because the company has failed to meet expectations.
3. The size of the company, its market value and possible problems
In 1999 Apple, at $8.45 a share, was considered overvalued. Today, at more than $610 a share, it’s considered cheap and rated a buy. The reason it has risen, and is expected to keep rising, is its business volume, the size of the company and its current market value, which is higher than Google’s. Apple is now worth even more than the whole IBEX 35 (the benchmark index of the Spanish stock market): a company with cash and a solid business model.
If tomorrow, for whatever reason, Apple had a problem (a factory closure, a multimillion-dollar lawsuit, a poor supply forecast for its product), this would affect Apple’s business model and its annual profits, so with lower profits than the previous year, the share price couldn’t stay the same. In other words, it would have to be lower.
Example: When the Japan earthquake struck, Inditex was affected, as the news said that some of the company’s factories in Japan had been hit. Inditex began to fall. Once it was reported that the stores had not been damaged, the share started to rise. Anyone who had bought shares in the company would have seen a gain of more than 11% in a few days.
Faced with news like this, some investors get scared and start selling so as not to lose money. Other investors know it’s a temporary situation and that the company will eventually pull through and meet its forecast, so they take the opportunity to buy more shares now that the price has dipped a little.
Another extreme case would be a company with a market value of 12,000 million facing a lawsuit worth 20,000 million. In that case we’d be talking about the company going bankrupt, so every investor with money in it would automatically lose it.
As we said at the start, because the market is based on supply and demand, in a situation like this it could become impossible to sell: when orders are matched, everyone would be selling but no one would be buying. It’s a very extreme case, but one that could happen, and in fact it already has.
4. The global economy
A weak global economy scares investors. When we hear that Greece is in trouble, or that Spain or Italy might need a bailout, panic usually spreads through European stock markets. Although a situation like this can trigger a sharp fall across the whole index, the truth is that some companies have hit their highs while the rest were losing value. That has been the case with Inditex, a company currently at its all-time high despite the crisis.
Of course, we come back to the same point: while those who own shares decide to sell so as not to lose, those on the outside decide to buy while the share is cheap in order to profit (as long as they believe the situation will improve).
In summary
If a company makes a profit of 2 million euros and its shares trade at €4, and it then manages to double its profit, the share price will rise, because it will be given a target price based on its size, profits and growth forecasts. That’s why we say that when investing, we should know the company’s plans and its management team. If you think the new management team will be able to increase the company’s profits, the investment will pay off. On the other hand, if a company announces it has hired a manager who has bankrupted four companies, investors are unlikely to trust its future.
When we say that stock market investing involves a lot of psychology, it’s partly because we have to “guess” what other investors will do in response to a particular piece of news or situation, and so get ahead of them. Sometimes, when share prices fall, we also have to work out whether we should sell our shares, hold them or take the opportunity to buy more. Read Falling stocks: sell, buy or hold? In other situations, even though the company has had some “specific problem”, it pays good dividends, so investors will probably decide not to sell. Many factors play a part in shares rising or falling, but prices only move for one reason: investors buy or sell shares. What will make them sell or buy? We’ve basically explained it.
Further reading
- Investing in a volatile stock market: investment strategies
- Stock market investing for beginners
- Controlling risk in the stock market: the ball system
Featured image: Don DeBold, CC BY 2.0, via Flickr.
