4 basic concepts to help you understand what causes stock prices to change


Stocks can--and do--create a great deal of wealth, they aren't
without risk.

Marie-Christine Daignault | Desjardins Group

Over the last few decades, interest in the stock market has grown exponentially. What was once a toy of the rich has now become accessible to anyone who wants to grow their wealth. Despite their popularity, however, most people don't fully understand stocks...

We've broken down some basic concepts for you, because although stocks can--and do--create a great deal of wealth, they aren't without risks. As the saying goes, "forewarned is forearmed."

1. Supply and demand
Understanding supply and demand is easy. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

What's more difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

2. Market capitalization
The main theory is that the price movement of a stock indicates what investors feel a company is worth. But don't equate a company's value with the stock price.

The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding.

Here's an example:
Company 1
·         Share value: $100
·         Shares outstanding: 1,000,000
·         Company's value: $100,000,000 (1,000,000 shares outstanding x $100 per share)

Company 2
·         Share value: $50
·         Shares outstanding: 5,000,000
·         Company's value: $250,000,000 (5,000,000 shares outstanding x $50 per share)

To further complicate things, the price of a stock doesn't only reflect a company's current value--it also reflects the growth that investors expect in the future.

3. Earnings
The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them.

It makes sense when you think about it. If a company never makes money, they aren't going to stay in business. Public companies are required to report their earnings 4 times a year (once every quarter). Wall Street watches with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection.

If a company's results surprise (are better than expected), the price jumps.

If a company's results disappoint (are worse than expected), then the price falls.

Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if that were the case!

During the dot-com bubble, for example, dozens of Internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most all Internet companies saw their values shrink to a fraction of their highs.

Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks.

Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the P/E ratio , while others are extremely complicated and obscure with names like Chaikin Oscillator or Moving Average Convergence Divergence (MACD).

4. Volatility
So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stocks will change in price while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell.

The only thing we do know with certainty is that stocks are volatile and can change in price very rapidly.

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