Why do Stock Prices Move?

It's a fairly straightforward connection to make that stock prices are somehow related to a company's earnings. But exactly what makes stock prices move, and how? It's important to understand the answers to these questions so that you can develop a reliable investment strategy. The fact is that a stock's price rises or falls based on changes in the market's perception of the stock's future earnings and the confidence (or lack thereof) investors have that those earnings will be achieved. If stock prices reacted solely based on a company's meeting or missing its earnings goals, then a company that missed its goal or estimate for its earnings per share (EPS) by just one penny, for example, should see its stock price go down by roughly the same percentage amount. For instance, let's say that ABC Corporation was expected to make 12 cents per share in the second quarter, but only made a profit of 11 cents; it missed the estimates by about 8 percent. Consequently, it would be reasonable to expect the company's stock price to drop by about the same amount – 8 percent. But in the real world, the actual occurrences are often dramatically different.

A company that misses its estimates by a penny can see its stock price drop by 30-, 40-, or even 50 percent or more. Why such a drastic decline? Because of fear among investors that the current quarter's lower earnings may be an indication of bad things to come for the company; for instance, the company's targeted earnings growth may not be achievable. In other words, investors may fear that what the company had anticipated as a 20 percent growth rate for the next few years may turn out to be only 10 or 15 percent. This perception, whether rational or not, lowers investors' confidence in the company's future earnings potential, and this lowered confidence is often reflected in remarkable drops in the price of the stock.

If you think that a 30- to 50 percent drop in stock price is a rather stiff penalty to pay for a company that missed its earnings goal by only one penny in one quarter, you must keep in mind that the size of the drop is relative to the change in expectations of future company growth. If the fear is that a company's growth rate is slowing from 20 percent to 10 percent – in effect, decreasing by one-half – then you can see that it's not unreasonable to expect a drop of 50 percent or even more in the company's stock price.

So, current earnings are only the most visible piece of the market's valuation of a stock. The two major cornerstones are the market's perception of future earnings and investors' confidence that those earnings will be achieved. Market perception is influenced by many factors. A favorable research report with high projected earnings can make the market take notice of a company. The release of a new product or the arrival of a new and aggressive management team can also gain the market's attention. All of these events would be perceived as fueling future earnings, and this perception would be reflected in the company's price-to-earnings (P/E) ratio. Price-to-earnings is the company's stock price divided by its most recent earnings; literally, the P/E is what the market has agreed to pay for the company's future earnings, which is based on the market's perception of what those earnings will be. However, those perceptions of a company's potential can quickly change, resulting in a dramatic effect on the price of its stock. When a company fails to meet the market's expectations, the drop in stock price can be crushing.

Although market perception can change radically and quickly, the change in stock price often takes place over time as a wave of knowledge moves through the market. At first, the knowledge or concern is limited to a few people, such as analysts who follow the stock closely and favored investors. The wave then spreads as the information becomes more public. Eventually, clients further down the pecking order are informed by their brokers. The revised estimates then hit the media, at which time the general public becomes aware of the 'new' information.

The first sign that the revised information has become public may be a sharp drop in the stock's price. In fact, the stock might gap up or down, opening 10- to 20 percent higher or lower than it closed the day before. But it may take several weeks or months for the full effect of the change in market perception to be reflected in the price of the stock. One reason for this delay is that institutional investors take a long time to build (or sell off) a position in a stock because of the size of their holdings. So even though the wave of knowledge began with that first nugget of information, the change in market perception won't be complete until the institutions have opened or closed their positions.

Investor confidence is the other crucial factor in the structure of stock valuation. To maintain a stock's valuation, confidence that future earnings will actually occur is just as important as the market's perception that the EPS growth rate will be high. It should be obvious that an investor would be willing to pay more for a stock that he or she is confident will continue to grow at a rate of 20 percent than one in which such certainty didn't exist.

Confidence is based on a company's past performance, and it usually doesn't come or go quickly. Once a company has a history of consistently meeting or exceeding its earnings projections quarter after quarter, investors become confident that it will continue to do so. For instance, if a company has grown at a rate of 20 percent per year for a number of years, it becomes easy to believe that it'll continue to do so if that's what the analysts are projecting. A strong earnings history provides confidence in the projected future earnings. This confidence in the company's future earning ability is reflected in a higher P/E; in other words, a higher stock price compared with current earnings.

The combination of market perception and investor confidence in the future earnings growth of a company is what drives stock prices and thus P/E ratios. Changes in either or both create a change in the price of the company's stock, whether up or down.

For a discussion of some of the events that can influence investor outlooks, please read the article How Events affect Perception and Investor Confidence.

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