The Economics of Stock Price Changes



Stock prices fluctuate with the ebb of news flow. However, from a long term fundamental perspective, there are two broad classes of new information that would typically lead to a reassessment of the underlying valuation of the company concerned, resulting in changes in the prices of its shares. These are:

Cash-flow news: this is new information that changes market expectations about the expected future cash flows from owning stock;

Discount rate news: this is any information that alters the rate at which expected future cash flows are discounted.

In general, any news that causes market expectations of the discount rate to fall results in an increase in the present value of the expected cashflows. Therefore, such news would be met with positive share price response.

Furthermore, as a rule of thumb, any news that results in expectations of lower cashflows than previously thought would result in negative share price response as the shares would be deemed less valuable.

One key point to take from all of the above is that what really matters to investors is not news flows, new information or earnings or central bank announcements...and all the other things you often hear mentioned in the media. New information only matters in so far as it presents a new view of the world that differs from investors' expectations. Hence the stock market has often been described as the 'expectations machine'!

Overall, it is a combination of investors' sentiments, attitudes and expectations (and in particular, changes in those expectations) that ultimately lead to movements in prices.

P.S.: Do not confuse a company's value with its stock price. As explained above, the stock price is simply the present value of expected future cashflows. A company's value on the other hand is the sum of the total value of all equity and debt capital. The market capitalisation of a company is the total value of its equity capital. This is the stock price multiplied by the number of shares outstanding.

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