Why does the stock price of a publicly traded company move up or down on any given day? What does the share price of common stock actually represent other than a number on the financial page of the newspaper? Are we doing move than just throwing darts at the page in the short term? Fundamentally, classic finance theory tells us that the price of a company’s common stock is the present value of all of its future cash flows. For example, the price of stock is really the worth of all the company’s dividend payments to its individual stock holders in today’s dollar values. But, what if a company does not issue dividends? What does a company do with its earnings if it does not redistribute them to its owners (the shareholders)? It invests that money back into the business in the form of new factories, new inventory, a larger staff, etc. Those retained earnings could have been given back to the owners as dividends, but they weren’t. They were used for the good of the business instead. So, those retained earnings are also considered as cash flows which make up the stock price.
What moves the stock prices in the short term? One day the stock of McDonald’s (Stock Symbol: MCD) can be over $57 per share. The next day, the stock could drop down to under $56 per share. This actually happened late last month. McDonald’s has approximately 1.09 billion shares outstanding. So, that equates to a market capitalization of $62.1 billion when the share price is $57 per share. When the share dropped in one day just one dollar per share, the company lost $1.1 billion in value. Did McDonald’s really have such a horrible day last month that it was worth $1 billion dollars less than it had been worth just the previous 24 hours prior? No!
The price of common stocks is not rational in the short term. That is the essence of what drives short term stock price movement, irrational behavior on the part of investors. The human factor makes the stock market volatile. If we consider all investors as rational, then each investor will value the stock rationally and invest in an expected pattern, buying stock and raising the price offered based on information about the company in question’s financial soundness and ability to turn a profit. Emotion is what rules investing in the short term (six months or less) and not rational behavior. Gossip and television pundit commentary drive the price of a particular stock higher or lower in a short time horizon.
What moves the price of a stock in the long term? A rational investor would value each company’s common stock on its fundamental value and technical analysis. Then, he or she would make an investing decision based on merit of that company’s financial fundamentals such as revenue and profit growth, dividends, etc. If the company has good fundamental finances and principles, then it’s stock price will continue to do well over the long run (six months or more). And, eventually the equilibrium price balanced by the laws of supply and demand will be reached again and valuing the company based on fundamentals and not emotion.
So, what does this all mean? Okay, granted, I have thrown a lot of classic finance theory at you today. But, what is the one talking point that you should take away from all this? You need to only consider investing if you are in it for the long term. Investing over a long period of time is the only way to take the human emotions out of the equation. Do not leave your investments up to the talking heads on television or the newest hot tip that you overheard at the company water cooler yesterday morning. When you conduct you own research and due diligence for your stock investing, you should only consider companies that you want to own for the long term. I’m not saying that you have to be wed to these stocks, but in order to take out the emotional roller coaster, you should consider holding on to your stocks for many months if not years to come.