Why Do Stocks Actually Change In Value?
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If you're just starting out on your financial journey, the complexities of the stock market can seem like a concrete octopus: impenetrably dense and highly convoluted and why the fuck does this thing exist in the first place?
Investors and market watchers often find themselves contemplating the intricate dance of rising and falling stock prices. Even the pros get tripped up by why stocks rise and fall, and their future prospects for gains or losses. Just check out industry veteran and occasional talking head Jim Cramer, who is so infamously bad at short-term economic outlooks that he told everyone to stay away from Nvidia in September 2022. At time of writing (May 2023), Nvidia is up nearly 200% since he made that call.
So why do stocks change in value? Let's talk about the factors at play, as there are likely way more than you'd think....
Stocks Change In Value: The Impact of Company Performance
A company's performance is often a central driver behind the ebb and flow of its stock price. If you think about it, it's pretty intuitive. When a company is faring well—seeing an increase in profits, expanding its operations, adding to its customer base—it's like an irresistible melody that draws investors closer in a concept called "guidance." If a company guides higher than they did previously, that's the company telling prospective investors that the gravy train has rolled out of the station. If they guide lower, that's a sign for short-term-minded investors to run as the company likely won't be as valuable in the near-term.
Now, this financial symphony can hit various high notes. Perhaps sales are soaring high, painting a picture of a company with a desirable product or service. Maybe the company is consistently paying down its debts, illustrating strong financial management. Or it could be that it's returning money to shareholders via dividends or buybacks—an overture that's music to an investor's ears. Let's take the Nvidia example from the intro.
Nvidia is essentially a monopolistic computer microchip manufacturer that powers Graphical Processing Units (GPUs) that run some of the world's most powerful computers. While we may have used these computers back in the 1960's to send someone to the moon, nowadays we play Diablo IV on them. But what is the most recent breakthrough technology that relies almost entirely on GPU's? Artificial intelligence! That's right! Everyone's favorite new buzzword, ChatGPT, runs on GPU's, as do its peers and competitors. Thanks to the explosion of A.I initiatives, Nvidia was able to guide much, much, much higher in both the short-term and long-term revenue of the company in its Q1 2023 earnings call. This caused the stock to rocket 35% in after hours trading, and it sent the market capitalization of the company to over $1 trillion the following day.
But the fundamental refrain remains the same: a prospering company often heralds a flourishing stock price. An increase in stock price is like applause, recognizing the company's impressive performance, and encouraging more investors to buy its shares.
A Glimpse into Tomorrow: The Power of Future Growth Prospects
The stock market is as much a stage for future potential as it is a reflection of present achievements. A company might not be basking in the golden glow of profitability yet, but its stock price can still rise. How so, you ask? The answer lies in the enchanting promise of growth.
Consider a start-up technology company—still young, not yet profitable, but armed with a revolutionary product or service. This promising contender can be perceived by investors as a dark horse, primed for a spectacular sprint in the growth race. This optimism, this anticipation of future success, can drive up the stock price even before the company has hit its stride. Thus, the shimmering mirage of future growth can be enough to elevate a company's stock value today.
A Sea of Emotions: The Influence of Market Sentiment
Investors are emotional creatures, and these emotions often color the canvas of the stock market. This collective mood of investors—termed 'market sentiment'—can significantly impact stock prices. When investors are optimistic, stock prices can rise like a rocket.
But beware—the sea of market sentiment can be as tempestuous as it is vast. Positive sentiment can sometimes inflate speculative bubbles—situations where prices surge way beyond their intrinsic values, creating an unsustainable situation that eventually bursts. It's a stark reminder of the age-old wisdom, "What goes up, must come down." While positivity can elevate stock prices, it's crucial to discern between sound optimism and unfounded exuberance.
The Grand Landscape: Role of Economic Factors
The stock market doesn't exist in a vacuum—it's part of the larger economic landscape. Thus, broad economic indicators often play a substantial role in stock valuation. A robust economy often sets the stage for healthy corporate profits, which can, in turn, inflate stock prices.
Conversely, an economic downturn can cast a long shadow over stock prices, causing them to stagnate or even drop. Furthermore, policy decisions made by central banks can ripple through the market, affecting stock prices. For instance, in an environment of low interest rates, stocks become more attractive compared to bonds or savings, leading to increased demand and, consequently, a rise in stock prices.
The Classic Dance: Demand and Supply
At its very core, the stock market is a grand ballroom where the classic dance of demand and supply unfolds. When more investors are looking to buy a stock than to sell it, the stock price tends to ascend. Conversely, if more shares are up for sale than there are buyers, the price takes a tumble.
This principle might seem simplistic, but it's instrumental in setting stock prices. However, it's vital to remember that the market doesn't always mirror a company's actual worth—it's more of a reflection of what investors think the company is worth. The perception of value can sometimes stray from the reality, leading to price fluctuations that might seem irrational at first glance.
The Game Changers: Corporate Actions
Corporate actions, such as stock splits, dividends, mergers and acquisitions, or buybacks, can directly impact a company's stock price. When a company announces a stock split, it increases its share count, making them more accessible to average investors. This heightened accessibility can boost demand and, consequently, the stock price.
Similarly, when a company decides to buy back its shares, it can spur a rise in the stock price. Buybacks reduce the number of shares available in the market, which can elevate the stock's earnings per share and potentially make it more appealing to investors.
Wrapping Up: The Stock Market - A Beautiful Symphony of Factors
Demystifying why stocks increase in value isn't as formidable as it first appears. It all boils down to the complex interplay of various elements—the company's current performance, its future growth prospects, market sentiment, broad economic indicators, the fundamental dance of demand and supply, and influential corporate actions.
But remember—the stock market is as unpredictable as it is fascinating. It sways to a multitude of tunes, some of which may not directly connect to a company's performance or value. A rising stock price often resonates with a company's stellar performance or a promising future, but it can sometimes echo unfounded optimism or manipulative tactics.
So, as you wade into the enthralling world of investing, remember to keep a keen eye and an open mind. Conduct thorough research, stay informed, and always ensure your decisions align with your financial goals and risk tolerance.