A common question is what determines stock prices. One correct but useless answer would be “whatever people are willing to pay at the current time.” It is true that an item, whether it be a share of stock or a bottle of soda will be priced based on what people are willing to pay at the current time. As with the bottle of soda, however, there are various predictable factors that will affect the price of stocks. In this series of posts I’ll discuss some of these factors.
Stock pricing is due to a variety of factors that I’ll call fundamental factors, comparative factors, emotion factors, and event factors. Fundamental factors include things like earnings, dividends, and potential opportunities for the company. These factors are based on fundamentals of the company. Some are known, like current earnings and dividends, and some need to be predicted, like future earnings and growth potential.
Comparative factors involve comparisons of the potential risk and reward of investment in a particular stock with the risk and reward of other possible investments. On the risk spectrum stocks fall between bonds and options in the risk spectrum, and therefore tend to be priced for a greater return than bonds but a lessor return than options.
Emotion factors involve concepts like momentum. Investors will tend to buy stocks that are going up because they expect it to continue to go up. For example, if a stock has gone up 50% in a month investors may start to assume that the trend will continue and therefore buy shares. A stock that is falling has a similar momentum, where shares may languish at low prices for months due to fear of further drops.
Event factors are thing s like new analyst recommendations, news events that affect a company directly or its business, or reports of company earnings and their comparison with expected numbers.
In the coming series I go into each of these factors in more detail. This starts with a discussion of the fundamental factors: https://smallivy.wordpress.com/2010/12/07/how-stocks-are-priced-part-2-fundamental-factors/
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing