Why Stock Prices Fluctuate: Valuation Models Explained
This paper examines the determinants of stock prices, focusing on why stock prices fluctuate over time. It surveys major valuation frameworks, including the dividend discount model, asset-based valuation, and the efficient market hypothesis (EMH), evaluating each model's strengths and limitations. The paper argues that investor irrationality, capital gains expectations, program trading, and the constant flow of new information collectively drive stock price movements. Rather than a single rational equilibrium, stock prices represent an aggregate of shifting investor sentiment, risk preferences, and interpretations of future cash flows, making price fluctuation an inherent feature of financial markets.
- Introduction: Stocks as present value of future cash flows
- Stock Valuation Models: Dividend discount and asset-based valuation limits
- Capital Gains and Investor Rationality: Why investors are not purely rational actors
- Why Stock Prices Fluctuate: Supply, demand, information, and program trading
- The Efficient Market Hypothesis: EMH theory, tests, and real-world applicability
- Conclusions: Multiple factors drive ongoing stock price changes
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What makes this paper effective
- The paper moves logically from foundational valuation theory (dividend discount model, asset-based valuation) toward more complex real-world factors (investor irrationality, program trading, EMH), building the argument in a clear sequence.
- It uses a well-chosen concrete example — the divergent views on Tesla's future prospects — to illustrate the abstract concept of market price as an aggregate of investor opinions.
- The conclusion synthesizes multiple causal factors (expected cash flows, capital gains, discount rates, program trading, risk preferences) without oversimplifying, reflecting the paper's underlying argument about complexity.
Key academic technique demonstrated
The paper demonstrates effective critical evaluation of competing models: it presents each valuation framework, identifies where it holds, and then explains its limitations before introducing the next framework. This approach — apply, test, refine — mirrors standard analytical writing in finance and economics.
Structure breakdown
The paper opens with a brief framing paragraph before moving into a formal introduction that defines stocks and establishes the present-value framework. Two central body sections address valuation models and the role of capital gains and irrationality. A shorter dedicated section covers program trading and price volatility, followed by an EMH discussion. The conclusion consolidates the multi-factor explanation for stock price fluctuation. The structure is well-organized for an undergraduate finance essay at roughly 700 words.
Introduction
Stock prices are determined by a range of interacting forces. Several models attempt to explain stock valuation, including the dividend discount model and the efficient market hypothesis. For many investors, capital gains are the key to a company's value, and the EMH would thus apply. Stock prices reflect the aggregate sentiment about a company's future prospects. These sentiments constantly change based on new information being released and interpreted against what is already known about the company, its industry, its competitors, and the broader economy. The constant adjustments in stock prices reflect this collective analysis of all available information and the ongoing reassessment of a company's future prospects.
A stock is a share in the ownership of a company. In theory, a share entitles the holder to a proportional share of future income. There are different schools of thought about what exactly this entails — specifically whether it includes capital gains or not. The basic concept, however, is that the stock price represents the present value of future cash flows (Cherewyk, 2015). The simplest version of this idea is embodied in the dividend discount model, which is predicated on the notion that a stock's price equals the present value of expected future dividends. Under this model, even a stock that currently pays no dividends is assumed to carry some expectation of future dividends, even when management has no stated plans to pay them in the near term.
Stock Valuation Models
The dividend discount model of stock valuation may have merit for stable companies, where dividends are largely predictable and there is a reasonable expectation that future cash flows will materialize. In practice, however, this model does not easily apply to all stocks. For companies in industries experiencing rapid change, there is a high level of volatility with respect to where future cash flows may end up. When it is difficult to predict future cash flows, it becomes equally difficult to derive a reasonable valuation for a company.
Another theory holds that stock value reflects the value of a company's assets — essentially the terminal value of the firm. This view might apply to a company nearing bankruptcy, but most companies do have ongoing future cash flows, and because a share entitles its holder to a portion of those cash flows, they must be incorporated into any valuation.
Capital Gains and Investor Rationality
Recognizing that book value and dividends alone cannot fully explain stock prices brings the role of capital gains to the fore. One school of thought holds that investors are perfectly rational and would only pay for known future cash flows; anything beyond that, the argument goes, amounts to speculation. However, estimating future dividend growth by extrapolating past trends is not substantially different from estimating sales and profit growth using historical data and knowledge of a company's business. Furthermore, investors are not rational, and they never have been (Elton, Gruber, & Busse, 2002). Investor rationality is a convenient theoretical assumption that makes economic models tractable, but it has never been demonstrated to hold consistently in the real world.
Capital gains are a legitimate form of investment return because they reflect genuine company growth. Most companies do grow, and that growth is part of an organic process — though investors will differ in how they assess any particular company's growth potential. The market price of a stock is not the "correct" price but rather an aggregate of what different investors believe the correct price to be. The widely divergent views on Tesla's future prospects serve as a vivid example (Rosevear & Sparks, 2015). The business environment is sufficiently complex, with so many moving parts, that anyone who believes their single vision of a company's future value is the one true vision is simply mistaken.
References
Basu, S. (1977). Investment performance of common stocks in relation to their P/E ratio: A test of the efficient market hypothesis. The Journal of Finance, 32(3), 663–682.
Cherewyk, P. (2015). Valuing firms using present value of free cash flows. Investopedia. Retrieved April 30, 2015, from http://www.investopedia.com/articles/fundamental-analysis/11/present-value-free-cash-flow.asp
Elton, E., Gruber, M., & Busse, J. (2002). Are investors rational? Choices among index funds. New York University. Retrieved April 30, 2015, from
Kirilenko, A., Kyle, A., Samadi, M., & Tuzun, T. (2011). The flash crash: The impact of high frequency trading on an electronic market. Sloan School of Management. Retrieved April 30, 2015, from
Rosevear, J., & Sparks, D. (2015). Bull vs. bear: Tesla Motors. Motley Fool. Retrieved April 20, 2015, from
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