Company performance on stock prices

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Large investment organizations throw a lot of time, money, effort, computing power, and manpower at the problem of analyzing stocks.  Many of them employ the same types of models that investment banks use to try to find the true value of a company.  Some of these models, like the dividend discount model, are fairly simple, and value the company based on a small number of variables.  Other models are more complex and employ a variety of different factors.  One of the most common models you’ll find is the Discounted Cash Flow Model (or DCFM), which essentially states that a company’s true market value is based on its future earnings, discounted back to today’s dollar value.  We’ll talk about the DCFM in a different article, but for now it’s important to note the key variable in the DCFM: earnings.

If a company is making a lot of money, then its shareholders are entitled to a lot of money.  On the other hand, if it’s losing money, its shareholders will likely lose whatever money they invested.  That’s why a company’s earnings are the biggest factor in analysts’ estimation of its stock price.

Have you ever noticed how a stock’s price can tend to get a little erratic when its CEO and CFO report on the company’s earnings for the previous quarter?  That’s because analysts are using the latest information, provided by the company, to update their estimations.  If a company didn’t sell as much as everyone thought it would, the models will show that the company should have a lower stock price, and vice versa.  After these calculations are made, large investment firms will buy or sell shares of the company’s stock to reflect their estimations.  This is frequently why you see such big moves in a stock price around earnings season.  Previous estimates of the company’s performance could have been so wrong or right that there’s a widespread movement to buy or sell the stock, which can cause huge fluctuations in its price.

Other performance factors also affect a company’s stock.  If a company is slowly losing sales to a competitor, it could cause demand for its stock to drop, causing the price to go down, even if its earnings are strong.  If a company was just sued, it could cause the company’s price to drop.  If a company just came up with a breakthrough technology, its stock could rise.  Ultimately, a stock is a reflection of its underlying company.

Investor outlook on stock prices

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A company’s fundamentals aren’t the only thing that can affect its supply and demand, and ultimately, its stock price.  Investor emotion can also affect how people buy and sell the stock, especially in the short-term.  Big headlines and positive reports can cause a company’s stock to jump, whereas negative headlines, lawsuits, lost patents, blocked mergers, and a variety of other negative issues can cause a company’s stock price to plummet.

Also, plain old greed and fear can drive a company’s stock price.  During the dot-com boom, we saw investors buying shares of any tech company they could get their hands on, regardless of whether it made a profit or not.  Everyone was so excited by the prospects of the “new economy” that they didn’t stop to consider that stock prices could fall.  The more they bought, the more stocks went up, and the more money they made.  However, at some point, a few of the smartest, savviest investors got wise and knew that the bubble was about to pop, so they started selling their shares.  That caused others to sell their shares, which caused a cascade of selling that led to a huge market crash.  None of the price movements were based on fundamental analysis, logic, or reason, it was all driven by large-scale emotional speculation.

This type of speculation happens all the time, everywhere.  There’s usually a moderate, calm, rational investor for every overly-emotional speculator, however, there are times where groupthink and group mentality can take over, causing large moves up or down.

The economy as a whole can also influence supply and demand.  We saw this in the Great Recession, when investors suddenly became fearful that the widespread downturn would provide all companies from accessing the credit that they needed to operate, or that a large portion of their customers would be too poor to buy their products.  In times like these, investors tend to buy, and more often sell stocks without considering individual company performance.

It’s a fine balance

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As you can see, there are a lot of factors at work when it comes to a company’s stock price.  Ultimately, it all boils down to supply and demand.  The more that investors want a stock (for whatever reason), the more they’ll buy the stock, and the higher the stock’s price will rise.  The less they want it (for whatever reason), the lower the stock will go.

In the long run, stocks tend to rise or fall based on how strong their underlying companies are.  Solid companies that continuously make profits and earn money will always rise, because at some point, they’ll be so low that the bargain hunters will come in and swoop up all of their shares, causing their price to rise.  Similarly, companies that run into trouble, or find that their products are no longer competitive in the market place will have low stocks, and may eventually go into bankruptcy, much as Kodak had to do when their photography products couldn’t compete with the digital cameras of the world.

There are a variety of factors that affect stocks in the short-term.  Value investors ignore these short-term spikes, even when they’re long and protracted.  Short-term traders thrive on them, following their moves up and down.  Oftentimes, investor sentiment and emotion can drive the price of a stock without any regard for its underlying fundamentals.  There’s an old saying that goes “the market can stay irrational longer than you can stay solvent.”  If you keep this in mind, do your own due diligence, practice solid risk management techniques, and develop a repeatable system, then hopefully you won’t have to worry about your own solvency.  In the next part of this series, we’ll show you how to analyze stocks to know whether they’re a good buy or not.  Read on!