Those of you just starting in the field of investment have most likely heard about one popular financial instrument: the stock. In fact, thousands of stocks are traded on the U.S. stock exchanges every day. But what exactly is a stock? Basically, a stock is a unit of ownership in a company. The value of that unit of ownership is based on a number of factors, including the total number of outstanding shares, the value of the equity of the company (what it owns less what it owes), the earnings the company produces now and is expected to produce in the future, as well as investor demand for the shares of the company.For example, let’s say you and I form a company together and decide that there will be only two shareholders (owners) with only one share each. If our company has only one asset of $10,000 and we have no liabilities (we don’t owe any money), our shares should be worth $5,000 each ($10,000 ÷ 2 = $5,000). If the company were sold today, together we would have a net worth of $10,000 (assets = $10,000; liabilities = 0).
However, if it is projected that our company will make $100,000 this year, $200,000 next year, and so on, then the value goes up on a cash flow basis as we will have earnings. Investors would say that we have only $10,000 in net worth now, but they see this growing dramatically over the next five years. Therefore, they value us at $1 million—in this case, 10 times next year’s projected earnings. This is very similar to how stocks are valued in the stock market.
Stocks are traded on organized stock exchanges like the New York Stock Exchange (NYSE) and through computerized markets, such as the National Association of Securities Dealers Automated Quotations (NAS- DAQ) system. Share prices move due to a variety of factors including as- sets, expected future earnings, and the supply of and demand for the shares of the company. Accurately determining the supply of and demand for a company’s stock is very important to finding good investments. This is what creates momentum, which can be either positive or negative for the price of the stock.
For example, scores of analysts from brokerage firms follow certain industries and companies. They have their own methods for determining the value of a company and its price per share. They typically issue earnings estimates and reports to advise their clients. Analyst, or Wall Street, expectation will drive the value of the shares before the actual earnings report is issued. If more investors feel the company will beat analyst pre- dictions, then the price of the shares will be bid up as there will be more buyers than sellers. If the majority of investors feels that the company’s earnings will disappoint “the street,” then the price will decline (also referred to as “offered down”). As stated earlier, the stock market is similar to an auction. If there are more bidders (buyers), prices will rise. This is referred to as “bidding up.” If there are more people offering (sellers), prices will fall.
For example, let’s say Citigroup (C) is expected by analysts to report earnings of $1 per share. If news starts to leak out that the earnings will be $1.25 per share, the share price will jump up in anticipation of the better-than-expected earnings. Then if Citigroup reports only $.75 per share, the stock price will theoretically fall dramatically, as the actual earnings do not meet initial expectations and are well below the revised expected earnings. The investors who bought the stock in anticipation of the better- than-expected earnings will sell it at any price to get out. This happens quite often in the market and causes sharp declines in the value of companies. It is not uncommon to see shares decline in price 25 to 50 per- cent in one day. Conversely, it is also common to see shares rise in value in a similar fashion.