By: Srinivas Kunnavakkam Vinchimoor
Do you ever wonder why stock prices go up and down all the time? This can seem confusing because the company represented by the stock does not change that much. A car company is still making the same cars, yet its value can change by billions of dollars in one year. The reason is simple. The market is made up of people, and people are emotional.
Google’s year-to-date stock price graph showing fluctuations over time
Before we continue, you may be confused on what the heck the stock market even is. The stock market is where people buy and sell small pieces of companies called shares. When you buy a share, you own a tiny part of that company. Prices go up and down based on how many people want to buy or sell, but over time they usually follow how well the company is doing. Now that you understand what the stock market is, we can go back to why prices move so much even when companies do not change that much.
Benjamin Graham,a pioneer of value investing and financial analysis, explained this using the idea of Mr Market. Mr Market is like a partner who offers to buy or sell a company every day. Some days he is excited and offers a very high price. Other days he is scared and offers a very low price. The business does not change that much, but the price does because of his mood.
This is actually a good thing. When prices drop, strong, reliable companies can go on sale. Smart investors wait for these moments and buy when prices are low. This is called buying with a margin of safety. It means buying something for less than what it is really worth, like getting ten dollars in exchange for five.
To know what a company is worth, investors look at its future profits. A company like Apple makes money by selling products. The more it sells and the more profit it keeps, the more valuable it is. There are two main questions investors ask: How fast will profits grow, and how long will those profits last? These two questions decide the value of a company.
Another important idea impacting market values is market capitalization. This is the total value of a company. It is calculated by multiplying the stock price by the number of shares. A stock with a low price is not always cheap. A stock with a high price is not always expensive. What matters is the total value of the company.
Investors also use something called the price to earnings ratio also known as the P/E ratio .This is found by dividing the stock price by the earnings per share. It shows how much you are paying for each dollar the company earns. If the P/E is 10, it means it would take 10 years of earnings to get your money back. A high P/E usually means the company is expected to grow fast. A low P/E can mean the company is risky or a good deal. A company with profits that last for many years is more valuable because those earnings keep adding up over time and feel more certain. A company with profits that only last a short time is shakier because even if it grows fast at first, the earnings can drop quickly and stop, making the business less reliable.
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