Factors That Affect Stock Prices That Every Trader Should Know
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The market determines the price of a stock, where the seller meets the buyer's demand. All investors know how important it is to predict and evaluate stock market trends. While there are no simple formulas to determine whether a stock price will go up or down, stockbrokers typically use these few key factors to determine a stock's potential price movement.
Fundamental Factors
Efficient stock markets move up or down based solely on fundamental factors, which are a combination of an earnings base and a valuation multiple. Essentially, this means that an owner of a stock is entitled to a share in a future stream of earnings.
What Moves Stock Prices?
Some of the earnings that a company reports may be used for distribution as dividends, while the company will retain the rest for future use. The valuation multiple is often used to represent the discounted future value of an earnings stream.
The Earnings Base
Although the concept of earnings base is presented in terms of an accounting measure, other measures can be used to evaluate a company's earnings power. For instance, free cash flow is a better alternative to earnings per share.
Different industries have metrics that can be used to measure a company's earnings power. Real estate investment trusts, for example, use a special measure known as funds from operations to evaluate a company's earnings power.
The Valuation Multiple
The valuation multiple is typically presented in terms of the discounted present value of a company's earnings stream. The discounted present value is calculated by taking the company's expected future earnings growth rate and dividing it by its current share price.
The discount rate is a function of perceived risk and inflation, which lowers the multiple and makes future earnings less valuable in an environment of higher interest rates.
In short, the fundamental factors that determine the price of a stock are its level of earnings base, expected growth rate, and discount rate.
Technical Factors
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In a perfect market, technical factors would not play a role in the price of a stock, but this is rarely the case. Technical factors are the external conditions that indirectly alter a stock's demand and supply.
Inflation
Inflation plays an integral role in the price of a stock, both as a fundamental and technical factor. Historically, low inflation has been associated with higher multiples, while high inflation has been associated with lower multiples. Similarly, deflation plays a negative role in a stock's price because it means that companies have lost some of their power.
Market Strength
Companies tend to track the market and their industry peers. This helps them gauge the overall market's movement and determine a majority of their share price's movement. For instance, a negative outlook for a certain industry or company can hurt other retailers in the same industry through a phenomenon known as "guilt by association."
Substitutes
For companies, competing for investment dollars is a part of their business model. They compete against other asset classes for their scarce capital. Substitutes to stocks such as government and corporate bonds, commodities, and foreign equities all play a role in stock market activity.
Incidental Transactions
Incidental transactions involve the purchase or sale of a stock with a motive unrelated to the company's intrinsic value. These transactions can be pre-arranged or driven by a company's goals. Although these transactions don't represent the votes cast by the company's board of directors, they can still affect the price.
Demographics
Various studies have been conducted on the demographics of investors. One of these studies focused on middle-aged and older investors. These individuals tend to withdraw from the market to meet their retirement needs.
Therefore, the more middle-aged investors there are in the market, the higher the valuation multiples.
Trends
A stock's movement is often dictated by short-term trends. Stocks that are moving up can gather momentum and increase their value solely based on them moving up at that particular time. Unfortunately, knowing that stocks are trending doesn't help to predict the future.
Liquidity
One of the most important factors that investors consider when assessing a stock is its liquidity. This is the amount of interest people have in it and how easy it would be to sell it if the need arose.
Large-cap stocks are often followed and heavily transacted. On the other hand, small-cap stocks are rarely on investors' radar screens.
News
It's hard to determine the exact impact of news or developments on a company or the stock market. However, it can certainly affect investor sentiment. Due to the nature of the markets and the various factors that affect them, news can quickly affect a stock's price.
News about a company's earnings report can also affect a stock's price. However, it's important to note that this information is not always related to the company's financial condition.
Generally, strong earnings are associated with higher stock prices. However, some companies that are not generating enough revenue to meet investors' expectations still have a high price.
Market Sentiment
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Market sentiment is a subjective and often biased view of the market. It can be very difficult to gauge the sentiment of individual investors.
For instance, knowing a company's future growth prospects can be beneficial, but it can also be very myopic to dwell on a single news item that keeps the stock price artificially high. Behavioral finance is a new field that studies the idea that markets are not efficiently managed. It uses psychology and social science to explain the inefficiencies of the markets.
The idea of behavioral finance was fully legitimized after Daniel Kahneman won the 2002 Nobel Prize in Economic Sciences. Many of the ideas in this field confirm observable suspicions.
Although behavioral finance is a new field, many investors claim to have already capitalized on its potential.
Looking To Start Trading Stocks?
Different types of investors rely on different factors when it comes to investing. Long-term investors tend to prioritize fundamentals, while short-term traders and investors tend to prioritize technical factors.
One significant improvement that the stock market has seen is the emergence of online stock market trading platforms. If you're looking to diversify your investment and get all the tools you need to start trading shares, Crystal Ball Markets provides the best online share trading platform, designed especially to help beginners understand market trends and make safe trades. Start trading currencies, stocks, energy, indices, and more today.