How do stocks get their price?
Most people are exposed to stocks, but few know how the price of the shares they own work. It took me a while to really understand how the markets worked. I had to read a couple books and listen to a lot of podcasts, but unless the markets interest you, I would not recommend doing that. However, I do think it is valuable to understand how stocks get their prices and what causes them to change.
Valuation
Sirius XM (SIRI) trades at $6.32 a share, and Apple (APPL) trades at $275.15 a share, and I think Sirius is a more expensive stock. That is not a typo. Apple is a much cheaper stock than Sirius. The reason I say that is because stocks trade on valuations, not on stock price. The most common valuation tool is the Price to Earnings ratio (P/E).
Price to Earnings Ratio
What is it?
This ratio tells you how much you are spending to get $1 of a company’s profit. The number is calculated by taking the price of the stock and dividing it by the earnings per share (EPS). In the above example, Sirius has a 33 P/E meaning it costs you $33 today to get $1 of Sirius profit. While Apple has a 23 P/E. Two assumptions probably just jumped into everyone’s mind: Why would I pay $23 or $33 for $1 that’s a horrible trade. Or some people think that stock picking is just as easy as choosing a company with a lower P/E. To answer the first question, the reason you pay $23 or $33 for a $1 today is because you believe that the company will eventually grow their profits to meet their valuation. The faster a company’s profits grow, the more investors are willing to pay now to get a piece of those ever-increasing profits. To answer the second question, is stock picking as simple as finding companies with low P/E ratios? No, it is not. Some companies will have high P/E because they are fast-growing, and people want in on the action. Sometimes stocks will have a high P/E because they are overvalued compared to their peers. Other companies will have a lower P/E because they are not fast-growing. Or they could be lower because the market is underestimating their potential.
Earnings Reports
Companies report their earnings every 3 months. In these reports, companies will announce a lot, not just their profits, but give insights into their business. Like restaurants will report stats on same-store sales and how trade policy will affect their supply chain. They will also provide guidance for investors for future quarters.
Analysts will listen to these calls and put their own spin on these reports to come up with their own valuations of the stock. For example, if a company says they expect profits to decrease in the next year, this will usually cause a stock to drop. If one of the primary valuation metrics is based on profits, you can easily understand why if a company guides down on future profits, a company’s stock will lose value. If a company has a high P/E, meaning analysts expect high growth, and the company misses expectations, this can cause the stock to lose value in a hurry.
Usually, around earnings reports, stocks will move a lot with investors making bets on what they think the earnings report will have in store. If people believe the report will be good, they will bid up the stock. The reason being that if the company has good news on the future outlook, this will cause analysts to rethink their valuations in a positive direction.
Breaking Company News
When companies break the news and surprise everyone, this can also cause the stock to move. The reason being is that any new story will cause investors to recheck their valuations. If the breaking story makes people believe that there will be increased revenue or profits, this will generally cause the stock to go up! If, however, the news is of a lawsuit or a recall, this will cause the stock to lose value.
The next subject on this matter to tackle is what is news and maybe more importantly, what is not news. I will use Apple for this example. Every fall, Apple announces a new iPhone. The date of the reveal is not news, and depending on the leaks that have happened ahead of time, maybe the announcements at the press conference will not be news. What is news is when Apple earlier this year announced an Apple-branded credit card. Nobody saw that coming!
The reason it is vital to differentiate news from common knowledge is that common knowledge will get priced into the stock. If everyone thinks the next iPhone is going to be an awesome can’t miss technology, they will start bidding up the stock before the announcement or vice versa.
World News
World news can rock the stock market. Because many of the biggest companies in the world are multi-national, what happens around the world will affect a companies bottom line and by connection its stock price. A current example of how world news can affect stocks is the ongoing US and China Trade War. So in China, they are having a tough time producing enough pigs to meet demand because of swine flu. Because of this, the global market price for pork will rise because of the lack of supply. This means companies in the pork business will have a chance to profit from this world news. Not all world events will have this apparent connection to business and profit. Still, people are always trying to use world events to predict and anticipate stock moves.
Market Movers
“A rising tide that lifts all boats.”
This is a saying that is used to describe improving economies. Regardless of your job or in this case, stock is directly affected. An improving economy will raise the conditions of everyone involved directly or indirectly. Because of the invention and popularity of Mutual Funds and ETFs, on big market moves, a lot of stocks will move together. If the news directly affects a company, its stock is likely to move more, but even if it is unrelated, it can still move.
A typical example is when a presidential candidate attacks Amazon and insists they need to be broken up. The shares of the attacked company will suffer (makes sense). But you will also see shares of completely unrelated stocks drop as well, let’s say McDonald’s. I am sure you are wondering why. The reason is that Amazon and Mcdonalds are both in the S&P 500, which is the most commonly traded group of stocks in the market. And because of the nature of Mutual Funds and ETFs, when companies stock moves, it will move the rest of the group with it.
In conclusion, the primary way a stock gets its price is based on current and potential future earnings (profit). This means that any news that can affect a company’s ability to generate current or future profits will affect its share price. The last factor in a stock’s changing price is just the market in general because of the popularity of Mutual Funds and ETFs. I wrote an entire article on those two funds if you are still confused about them. Hopefully, now after reading this, you will stop thinking a stock is expensive just because the price of the share is higher and demystified the change in the stock prices.
If you enjoyed this article or have any questions or comments write to me at huskdoes@gmail.com!
