Why Do Stock Prices Rise or Fall?
You must have sometimes heard sensational news about the value of a particular stock shooting up or plummeting sharply. But why do these events happen? We bring you a short article on how share prices move and what factors cause these movements.
Share prices rise and fall based on supply and demand. If more people want to buy a stock than sell it, the price goes up. If most people want to sell rather than buy the share, its price will decrease.
However, predicting whether a particular stock will have more sellers than buyers requires deeper research. There can be several motivations for buying a stock, ranging from a low valuation or the introduction of a new product line to a desire to take advantage of a market downturn.
Comprehending how the stock market works is the first step to understanding the factors that cause stock gains and declines. Knowing what determines the value of stocks can help you predict which ones are more likely to rise.
Why Do Stock Prices Rise?
Stocks are long-term equity securities with no predetermined maturity date. Simply put, they represent an ownership interest in a physical company.
Investors can buy or sell shares of publicly traded companies on a stock exchange via a bidding process (similar to an auction). Sellers post the prices at which they would like to sell their shares, and buyers similarly post the prices at which they would like to buy them. This difference between the bid and ask prices is known as the bid-ask spread.
Supply is derived from the number of investors who want to sell their shares. Demand comes from investors willing to buy them. When the number of buyers willing to pay the current price exceeds the number of sellers willing to sell at that price, the stock price rises to the level demanded by other sellers. To illustrate, we give a simplified example of how supply and demand work in the market:
Example of Supply and Demand
- Marco is willing to buy a share for €100.
- Ivana is willing to buy a share for €110.
- Jasmine is willing to buy a share for €120.
- Lucas is willing to sell his share for €110.
- The first posted trade will take place at a price of €110 when Ivana buys the share from Lucas.
- Adam is willing to sell his share for €120.
- This trade will occur when Jasmine enters the market and pays €120.
This example demonstrates how investor demand can drive up stock prices. After the first trade occurs at €110, no seller remains willing to accept such a low price. The next trade takes place at €120 because the number of buyers willing to pay the higher price exceeds the number of sellers willing to sell at the lower price.
What Will Make a Stock More Valuable?
If there is excess demand (i.e., more buyers than sellers) which ultimately increases the price of a stock, the attractiveness of that stock to potential investors must have increased. One of the factors that drive demand is the company’s valuation.
Companies can be valued in several different ways. Two common indicators considered in computing a company's value are earnings per share (EPS), which reveals a company's profitability, and the price-to-earnings ratio (P/E ratio), which divides a company's stock price by its earnings per share.
Profitability and Interest in Stocks
Earnings per share (EPS) represents a firm's profitability. It is also a metric for comparing it to other companies in the industry. For example, if a company is twice as profitable as its competitors in the same industry, it is more likely to attract investors.
EPS is calculated by dividing a company's earnings by the number of shares outstanding. If Techzilla reported a profit of €1 million last year while having one million shares outstanding, its EPS would be €1. If it has a profit of €2 million and one million shares outstanding this year, its EPS will rise to €2.
Compare that to Financex, which had a profit of €10 million and 20 million shares outstanding last year, giving Financex earnings per share of only 50 cents, although its total earnings were higher than Techzilla’s. If Financex earns a profit of 15 million euros this year with 20 million shares outstanding, its EPS will be 75 cents. Despite higher profits last year and higher earnings growth this year, Techzilla's valuation is higher because it has higher EPS.
In general, investors are more interested in companies with growing earnings.
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The P/E ratio is another comparative metric that investors use to value stocks. The P/E is simply a stock's price divided by its EPS. If Techzilla's share price is €50 and its EPS is €1, its P/E ratio is 50. If Financex's share price is €50 and its EPS is 50 cents, its P/E ratio is 100.
Simply put, a company with a lower P/E relative to competitors within the same industry should be more attractive to investors as it may be undervalued.
Why Do Stocks Rise and Fall?
While earnings per share and P/E ratio are standard indicators for valuing companies, many other factors can influence a stock's growth or decline. Some of them include:
Valuation, technical analysis, and other factors are sometimes not as important as global events. In times of great uncertainty or panic (e.g., the current war in Ukraine or the declaring the coronavirus to be a global pandemic), investors tend to sell stocks regardless of valuation or earnings.
Similarly, in times of great optimism, stocks tend to rise even if they are considered overvalued by traditional indicators. These events are called exogenous events because they occur outside typical models.
Any economic factors that can reduce a company's profitability can also cause a stock price to fall. Inflation is one example. Historically, high inflation has depressed share prices as it causes prices to rise, making business operations more expensive.
Current market trends
Sometimes stocks rise simply because they are trending. In a strategy known as "momentum investing" or "relative strength investing" investors buy stocks of growing companies and sell those they believe have peaked, hoping these trends are likely to continue. This momentum is self-fulfilling: the extra demand drives the shares of growing companies even further up. When selecting stocks, traders follow market trends instead of traditional valuation metrics.
Investors try to identify trends early to maximize the time they can profit from them - and shorten the time they hold declining stocks. Earnings from this strategy can be quite volatile, as it stands or falls on proper market timing. Some tools can help neutralize these risks, but they can by no means be eliminated.
A whole segment of market participants uses market data to determine which stocks to buy and when. Technical analysis relies only on price movements, which investors often track on charts, without considering other valuation factors. They try to identify typical patterns of price movements on charts, trying to infer their future development.
How to Predict When Stock Prices Will Rise?
Despite all methods of valuing shares, it is impossible to predict when share values will rise or fall with certainty. In the long term, however, the overall stock market grows. When looking for stocks that will rise in price, it is best to evaluate the factors that tend to increase prices. We have described some of these above.
The bottom line of investing is that although certain factors may indicate future stock movements, the best approach is to hold a diversified portfolio. Instead of putting all your eggs in one basket, owning many stocks and different asset classes can help you smooth out sharp fluctuations in portfolio value. After all, if one stock unexpectedly crashes, all the others will hold you up.