What Makes Stocks Go Up?
Stock prices are determined by the marketplace and what it’s willing to pay. There is no straightforward equation that shows precisely how and why stock values behave the way they do. However, there are three main forces that determine what causes stock prices to go up and down: fundamental factors, technical factors, and market sentiment. It all boils down to supply and demand. Investor expectations drive demand up or down. If you’re thinking about investing in the stock market, read on to find out more about what makes stocks go up.
- Fundamental factors show how stocks are valued through earnings and price-to-earnings ratios. Fundamentals go up and down with earnings projections.
- Technical factors are a mix of external factors that affect stock prices, including inflation and how market peers perform.
- Market sentiment is an important but hard-to-measure factor that isn’t based on fundamentals or technical factors. Instead, it’s based on the psychology of the market.
Fundamental factors illustrate how stock prices are valued. Long-term investors tend to focus on fundamental factors like earnings power and acknowledge that technical factors play a crucial role in stock values. Fundamental factors are based on two things:
- An earnings base, such as earnings per share (EPS), which is calculated by dividing total earnings by the number of outstanding shares.
- A valuation multiple, such as price-to-earnings ratio (P/E ratio). The P/E ratio is the current stock price divided by the EPS.
Owners of common stock have a claim on earnings. Earnings per share (EPS) shows this claim and is widely used to estimate a company’s value. Buyers of a company’s stock purchase a proportional share of future earnings.
Ideally, the price to earnings ratio (P/E ratio) would be similar across companies in the same industry. If the P/E ratio is too high, the stock is overpriced. If it’s too low, it’s under-priced and attractive to buyers. To calculate the P/E ratio, take the current stock price and divide it by the EPS. The value multiple is the price the market is willing to pay for the future earnings — commonly the P/E ratio. This ratio measures the current share price and how it is related to the earnings per share.
Some of the earnings may be distributed as dividends, with the balance being retained and reinvested in the company on behalf of its shareholders. Future earnings take into account current earnings and expected growth.
Public companies report earnings quarterly, and Wall Street observes those earnings. Analysts base future stock prices on earnings forecasts. If a company exceeds forecasted earnings, stock prices go up. Stock prices go down when earnings don’t meet expectations.
The Earnings Base
EPS shows the earnings base using accounting principles, but some prefer cash flow measures. Free cash flow per share also illustrates the earning power of a company.
The Valuation Multiple
The valuation multiple is forward-looking and expects earnings to increase. It’s based on the discounted present value of the future earnings stream and has two key factors:
- The earnings base of the company is expected to grow.
- The discount rate is used to calculate the current value of the future earnings stream.
Higher growth rates correlate to a higher multiple for the stock, while higher discount rates correlate to a lower multiple.
Discount rates go up with perceived risk. Riskier stocks earn a higher discount rate and a lower multiple. The discount rate is affected by inflation and, to some extent, interest rates. Higher inflation raises the discount rate and lowers the multiple. Future earnings have less value when inflation rates are elevated.
Interest rate increases mean higher borrowing prices and significantly affect housing-related stocks and other investments like real estate investment trusts (REITs).
A mix of external factors, called technical factors, also affects stock prices. Technical factors alter the supply and demand of a company’s shares, and some may indirectly affect fundamentals. A growing economy can indirectly lead to an increase in a company’s earnings. Technical factors likely appeal more to short-term investors, who are likely to focus on inflation, demographics, and trends.
Inflation is a major technical factor. Typically, low inflation drives high multiples or anticipated future growth. High inflation drives low multiples. Deflation is generally bad for the stock market because it results in a lack of pricing power by companies.
Economic Strength of Market and Peers
Stocks tend to follow the market within their sector or industry. Some investment firms believe that the overall market and sector performance, rather than individual company performance, determines most of a stock’s changes in value. Negative outlooks and adverse events may cause one stock to drag down other stocks in the same sector.
Companies compete globally for investment dollars with other asset classes. Substitutes for domestic equities include various types of bonds, commodities, real estate, and foreign equities. The demand for substitutes is hard to track, but it plays a vital role in overall stock valuation.
Incidental transactions are stock trades that are executed for reasons other than the belief in the intrinsic value of the stock. Such transactions include executive insider transactions, which are often scheduled or driven by portfolio objectives. Investors may also buy or short a stock to hedge a different investment. However, incidental transactions can move the price of stock even though they don’t indicate positive or negative sentiment toward a stock.
Investor demographics is the subject of research that focuses in large part on two dynamics:
- Middle-aged people tend to invest more in the market as they reach peak earning during their careers.
- Older investors tend to lean toward more conservative investments and pull out of the market as they use their money throughout retirement.
Researchers hypothesize that greater demand from middle-aged investors will drive demand for equities and higher valuation multiples.
Stocks may move along with a short-term trend, but they may also gain momentum and popularity. Trends may also cause stocks to lose value and do what is known as reverting to the mean, a process by which asset prices and returns ultimately revert back to the average, or mean, of the overall period. Trends are hard to predict, so trendy stocks aren’t necessarily the best for long-term investing.
Highly liquid stocks attract a lot of investor interest and are very responsive to news and other events. Liquidity is a key factor and often garners limited appreciation.
Trading volume represents liquidity and is a function of corporate communications related to the attention the company receives from the investment community. Large-cap stocks have high liquidity since they are closely followed and heavily traded.
Many small-cap stocks aren’t on investors’ radar screens, and due to limited followers and traders, they have what is known as a liquidity discount.
Image via Flickr by AndreasPoike
Market sentiment is a complex category of stock valuation that isn’t based on fundamental factors. It reflects the psychology of investors both individually and collectively. Market sentiment ultimately affects stock prices, but it’s hard to capture in numbers and formulas. In some cases, investors overlook fundamentals like P/E ratios and value a company’s stock higher, basing the increased share value on other factors.
Many investors believe that market sentiment and technical factors affect prices on a short-term basis, but fundamentals ultimately set long-term prices.
One example of market sentiment causing prices to increase was the technology-driven bubble of dot-com stocks. Investors were euphoric and speculated irrationally. Over-leveraged investors can cause a dramatic fall in prices if the market goes in the wrong direction and they’re forced to sell stocks.
Market sentiment is often subjective, biased, and unyielding. Investors can make a sound argument about a stock’s future growth possibilities, but the market may focus on other news and keep the stock artificially higher or lower. It may take time for investors to focus back on the fundamentals.
Market finance is studied in the growing field of behavioral finance. It assumes that markets often aren’t efficient, and the inefficiency can be explained through psychology and other social science disciplines. Behavioral finance studies confirm the observable suspicions that investors tend to exaggerate apparent data and react more to losses than gains. Investors tend to weigh losses more heavily than gains and stay in a mindset that doesn’t consider all fundamentals. Behavioral finance looks at unexplainable and mysterious happenings in the market.
News and unexpected happenings inside a company, industry, or global economy can influence investor sentiment. World markets are increasingly connected and are affected by political issues, mergers and acquisitions, unexpected events, and product breakthroughs. The impact of news is hard to measure, but it affects the markets, sometimes instantly.
I nvestors look toward various factors depending on their investment style and goals. Short-term investors tend to focus on more technical factors. Long-term investors look at fundamentals and technical factors. Popular beliefs hold that fundamentals play an important role in setting stock prices for the long term. Those beliefs lean toward short-term changes affected by technical factors and market sentiment. Many investment professionals look toward future developments in behavioral finance, especially since traditional theories of stock valuation have limitations that cannot be explained. When investing in the stock market, it’s imperative to consider what causes stock price to rise.