What Determines Stock Prices

¶ … determinants of stock prices, to explain why stock prices fluctuate. There are a number of models that seek to explain stock valuation, including the dividend growth model and the efficient market hypothesis. For many investors, capital gains are the key to a company's value, and EMH would thus apply. Stock prices reflect the aggregate sentiment about the future prospects of a company. These sentiments constantly change, based on new information being released and applied to what is already known about the company, its industry, its competitors and the economy at large. The constant stock price adjustments reflect this collective analysis of all information regarding a stock and the interpretation of its future prospects.

Introduction

A stock is a share in ownership of a company. In theory, a share entitles the holder to a proportional share of future income. There are different schools of thought as to what exactly this entails -- specifically whether it includes capital gains or not. But the basic concept is that the stock price is the present value of future cash flows (Cherewyk, 2015). The simplest version of this is embodied in the dividend discount model, which is predicated on the notion that a stock's price is the present value of the expected future dividends. In this model, a stock that does not currently have dividends is going to have some expected future dividends, even when management claims to have no plans to pay them any time soon.

Stock Valuation Models

The dividend discount model of stock valuation may have some merit where stable companies are concerned, where dividends are largely predictable such that there is a reasonable expectation that the future cash flows are going to manifest, the reality is that this model does not so easily extrapolate to all stocks. For some, their industries are in a state of flux, and there is a high level of volatility with respect to where their future cash flows could end up. When it is difficult to predict future cash flows, it is difficult to derive a reasonable valuation for a company.

Another theory about stock valuation is that it reflects the value of the assets, or what is essentially the terminal value of the company. This view might hold for a company that is nearing bankruptcy, but most companies do have future cash flows, and because a share entitles its holder to a portion of those future cash flows, they need to be incorporated into the calculation.

Knowing the book value and dividends are not entirely capable of explaining stock value brings the issue of capital gains to the fore. One school of thought is that investors are perfectly rational, and as such would only pay for known future cash flows. Anything else, the logic goes, is basically gambling. But of course, guessing at future dividend growth by extrapolating past trends is not substantially different from estimating sales and profit growth by examining past trends, and incorporating knowledge of the company's business. Further, investors are not rational and they never were (Elton, Gruber & Busse, 2002). Investor rationality is a nice theory that makes economic models work, but has never been demonstrated to hold in the real world.

Capital gains are a valid form of gain for an investment, as the reflect the growth of a company. That growth is not irrational, as most companies do grow. The reality is that this growth is part of an organic process, but there will be differences in how people view the growth potential a given company. The market price of a stock is not the "right" price, but an aggregate of what different investors view the right price to be. As a perfect example, consider the wildly varying views about the future prospects for Tesla (Rosevear & Sparks, 2015). The business environment is so complex, with so many moving parts, that anybody who believes that their vision of what a company's future business is worth is the one true vision is simply naive.

This actually cuts to the heart of why stock prices fluctuate. They fluctuate, in short, because of supply and demand. Supply and demand conditions change constantly. Minute-to-minute fluctuations are almost irrelevant to this discussion, but longer term fluctuations tend to reflect new information, or a shift in sentiment regarding the existing information. Announcements from the company, its suppliers, and its competitors all paint a picture of the operating environment and the company's ability to succeed in that environment. Economic data is released frequently, and much of that can affect perceptions about the operating environment. Stock prices fluctuate because the world never stops moving, and the market digests new information constantly.

In addition, a lot of trading these days is driven by program trades. Market volatility in particular can be affected by program trading, as it exacerbates price movements. If a stock, for example, dips below a specific position and triggers a sell-off, that will exacerbate the pre-existing price movement (Kirilenko et al., 2011). Program trading is based more on technical analysis than rational analysis of future cash flows. Thus, there are influencers on price movements that are not really related to future cash flows at all, as many market participants are betting on short-term movements.

But an investor does need to distinguish between short-term movements and long-run movements. Over the long run, the value of a company will largely reflect its performance in the market, which is to say the expected value of the future cash flows. Those cash flows might be, however, in the form of capital gains. Many investors look to growth stocks, because capital gains are seen as maybe being less certain than dividends, but far more immediate. Many growth companies in particular are more oriented towards seeking capital gains for their shareholders.

One theory that should be discussed is the efficient market hypothesis, which holds that stock prices reflect all known information about the company, and that this information has been built into the price. The EMH would theoretically hold for any stock with sufficient trading volume, hence why volatility can be greater in the summer months when volumes are lower. The EMH has been subject to numerous tests, and debates since its introduction (Basu, 1977), but still holds some water in that investors do seek to incorporate as much information as possible about the company before making their decisions.