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Wednesday, 8 March 2017

(Tradeview 2017) - What Makes The Price Of A Stock Go Up?

Bernie Klinder
Bernie Klinder, MBA, Entrepreneur, and active investor for +15 years
When you buy shares in a firm, you own a percentage of that company. Or in accounting terms: (assets - liabilities = shareholder equity). The stock price however is based (theoretically) on the previous number, plus the discounted cash flow of future earnings.
I'll spare you the math on discounted cash flows and other value calculations, but most institutional professionals invest based on a common set of formulas that determine where the stock price should be in the future given some basic assumptions of growth, future earnings, economic outlook, etc. So if a company is worth $100 million today and they are expected to increase sales and profit margin, the value of the firm will increase, as well as it's share price. (Typically that outlook is 3–5 years, it's hard to predict longer term). So if the future value is estimated to be near $120 million, then the stock price would rise about 20%.
That is, if all investors were rational.
Most retail investors are not rational, and tend to overvalue a firm. A recent example would be Nintendo, and the rush of inexperienced investors “betting” that the Pokemon Go craze would make the company a fortune. Astute investors read the fine print and knew that Nintendo was only going to see about 30% of the profits. So the stock quickly became overbought by retail investors, and shorted by the pros. The typical cycle looks like this:
Like any market, if there are more buyers than sellers, the price goes up (regardless if the real value of the firm has changed or not.) If the current stock price is $50 and no one is willing to sell their shares for $50, then they may bid higher. Conversely, if someone wants to sell their shares and no one is buying, they will have to either lower their price or hold the shares until prices recover. Any time there are more sellers than buyers, the price will fall.
Professional investors make their money by calculating the real value of a stock (this is not an exact science) and buying it below that value, and selling it when it hits a threshold above that value. In the short term, stock prices are based on often irrational expectations. Sooner or later, they return to their actual value.
Another example is Tesla - its market cap (share price x number of shares) is over $30 billion. (In comparison, Ford and GM are each worth about $50 billion) Today's stock price is around $230 per share, but Tesla’s actual book value is around $7.25 a share, or about $1 billion. The difference between those two numbers is the expectation of future earnings (that Tesla will be the next big thing). However, the + $200 a share difference (multiplied by 148 million shares) means that they need to sell a lot of cars. The professionals think that the stock is way overvalued, and as a result over half the shares of Tesla are currently being sold short (betting the price will fall dramatically.)
Dividends are typical paid by large, stable, mature companies that generate lots of cash. Growing companies reinvest their cash into the business in order to keep growing. Instead of offering a dividend with a yield of 2–4%, your “earnings” will be based on the gains in share price as the firm increases in value. It's easier for 1 billion dollar company to become a 2 billion dollar company, than for a 100 billion dollar company to double in size. So the behemoths reinvest a smaller overall percentage back into the business, and distribute the rest to shareholders.
Hope this was helpful.
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