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What causes stock prices to change?
Recently I spoke to a new investor, and he asked me, “A research report showed a valuation of 75c on the stock, and I bought it at 45c, how long will it take to grow to the target price?”
The only credible answer to the question is simply that it cannot be answered!
You see, the stock market is driven by supply and demand. That means whenever a stock is sold, a buyer and seller exchange money for share ownership in a company. The price for which the stock is purchased becomes the new market price of the stock.
When another share is sold, this price becomes the newest market price.
So for large companies where thousands of transactions take place between shareholders every day the stock price can change thousands of times. Because of these many transactions the changes in price tend to be smaller.
For smaller companies where less shares change hands every day it works differently.
Less transactions mean it is slower, and more difficult to match up buyers and sellers. Consequently, the changes in share price tend to be bigger in between transactions.
This happens either as sellers are hard up to sell a share, and willing to take less from a buyer. Or as buyers are clamouring to buy shares, willing to pay higher prices to sellers that might be few and far between.
Understanding the supply and demand part is simple.
This should make it clear that even though a valuation puts a certain target on a share price – there is no way to accurately predict if it will ever hit that target, nor when that will happen. And perhaps just as important – the movement in the share price won’t necessarily happen smoothly.
It could hit a target in a couple of trades if a share is highly illiquid or if big news is released, or it can take months or years based on investor sentiment and whether the catalysts for share price movement play out.
Simply put you’d have to figure out what makes people like a particular stock and dislike another stock.
This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.
That being said, the theory is that the short-term price movement of a stock indicates what investors feel a company is worth – the longer-term price movement is a reflection of the deeper seated value of a company. We often call this intrinsic value.
So how does the value of a share compare to its price?
I’m sure you’ve heard the term “Price is what you pay, value is what you get”.
So, in terms of a company with shares you invested in this is what it means:
Consider Zeder Investments as an example.
In February 2021, Zeder’s valuation was 433c, yet the share price was 265c. On 22 June 2021 the share price was 299c, although the company’s valuation is 425c.
Even though the valuation dropped, the share price went up between February 2021 and June 2021.
So what is behind this?
Well, sentiment has improved since February. The company paid investors a dividend and forecasts show that the agricultural industry will have a great 2021. And, as investors start seeing light at the end of the Covid-19 tunnel they might also be more willing to buy shares in the company.
In times of positive sentiment share prices often overshoot the valuation of the company because of investor euphoria and the belief that growth will continue to stay higher forever.
And in times of negative sentiment, share prices are often much lower than intrinsic value because investors are despondent and have basically given up hope.
So, what affects the sentiment for a stock?
Sentiment for stocks are affected by a number of factors:
• Political sentiment affects the outlook on a sector – if a law change such as expropriation or a new mining charter is on the horizon it slows investor appetite due to uncertainty about what the law holds for the future. This could affect the agriculture or mining sectors for example causing bad sentiment.
• New technology or discoveries – New technology can create both good or bad sentiment for a sector. Think of something like streaming video. It created an opportunity for companies like Netflix and YouTube to become multi-billion dollar businesses. But it also decimated the video rental industry. Investors often latch onto these new technologies and stocks in these sectors outperform (or underperform) massively. Sometimes sentiment gets carried away creating exaggerated movements in share price. Over the long term this will correct however.
• Short term news announcements – The announcement of a coming dividend, earnings growth or impending losses can affect the sentiment towards a share. Many times the effect of this is exaggerated in the short run, and corrects over time as investors digest the information unemotionally.
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How do you compare the values of companies and stocks to one another?
One mistake I often see investors make is directly comparing the share prices of companies.
You cannot do that.
Let’s look at Redefine and DRD Gold as an example.
Redefine’s share price is R4.16 today. DRD Gold’s share price is R15.03.
Does that mean DRD is worth three times what Redefine is worth?
You see, DRD Gold has a total market value (also called Market Capitalization) of R13.19 billion.
Redefine on the other hand has a market capitalization of R23.8 billion.
How’s this possible?
Well, companies don’t all have the same amount of shares in issue.
You see, Market Capitalization = Share Price x Shares in issue.
That’s why we use figures like earnings per share, PE ratio, Net asset Value per Share etc.
It gives us a way to evaluate a company’s performance relative to its shares.
The most important things to remember from this are:
1. At the most basic level, supply and demand determines the market price of a stock
2. Price times the number of shares outstanding is the value of a company. Just comparing the share price of two companies is useless.
3. Earnings and the value of assets theoretically point towards the value of a company. But due to sentiment investors don’t always objectively consider this.
There is no single theory to explain anything in the stock market. Things are always changing – and using your knowledge you always need to adapt.
Here’s to unleashing real value
Editor, Red Hot Penny Shares