We deal with quite a few mysteries in everyday life. Why does it always seem to rain on the weekend? Why does ice cream have to be high in fat? Why do we get so many credit card applications? And, for a lot of us, there’s at least one more puzzle: What causes stock prices to move?
Rainy weekends, saturated fat and credit card invitations may always be beyond our comprehension. But it’s not impossible to understand the economic and psychological mechanisms that determine stock prices.
Ultimately, the key word in stock price movements is earnings. When investors consider a company’s earnings, they typically look at the price/earnings ratio, or P/E. To determine P/E, you simply divide the company’s stock price by its earnings per share (a company’s profits divided by the number of outstanding shares). So, for example, if Company A sells for $40 and has earnings of $2.00 per share, then it has a P/E of 20.
Actually, a P/E isn’t just the end result of a company’s price divided by earnings per share; in fact, a P/E can help determine the company’s price. Let’s suppose that Company A’s earnings remain at $2.00 per share. But then, for whatever reason, investors become very excited about the company’s prospects. Now, they are willing to pay 40 times earnings for a share. With a P/E of 40 and earnings of $2.00, the stock would then sell for $80.
Sometimes, a stock’s price can move up without this increased willingness on the part of investors to pay more for each dollar of earnings.
Specifically, sharp increases in a company’s earnings estimate could cause stock prices to rise significantly. Let’s return to our example above. This time, let’s say that Company A’s P/E remains at 20. But if its projected earnings jump to $4.00 per share, its stock price should then trade at $80.
Of course, in the real world, price movements aren’t quite that neat and orderly – but you can still appreciate the impact of a company’s earnings and its P/E. However, keep this in mind: There is always a reason for stock prices to move – but there’s not always a good reason.
For a recent illustration of this point, you need look back no further than the late 1990s, when many “dot.com” companies were selling at enormously high P/Es – which, in turn, drove up the stock prices. A lot of these companies had little or no earnings, yet investors snapped them up, convinced that, one day, their investment would be rewarded. But in early 2000, the technology bubble burst, and it hasn’t reinflated since.
Thus far, we’ve just looked at a formulaic approach to stock price movements. But these quantitative factors – P/E and earnings per share – are obviously tied in to many qualitative elements. A shake-up in management might cause a stock to decline, while the unveiling of a promising new product could boost prices. Loss of a government contract is bad, while a favorable write-up in a business journal is good. A labor dispute is a negative; a labor settlement is positive. All these elements, and more besides, can affect a stock’s daily price movements, and, sooner or later, its P/E and earnings per share.
So, there you have it – a quick tutorial on why stock prices move the way they do.
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