In Joel Greenblatt’s book – The Little Book That Still Beats The Market, he answers the question of why does a company’s stock price fluctuate so wildly, and what you should do about it. Here’s an excerpt from the book:
Each day the newspaper lists the names of thousands of companies and the price at which people have been buying and selling an ownership share in each. The trading back and forth of these ownership shares takes place in a number of locations and over computer networks. These ownership shares are referred to as shares of stock, and collectively, this buying and selling activity is referred to as the stock market.
A company as large as IBM or General Motors might have divided its ownership stake into something like a billion equal shares. That means that if at one point during the year you can purchase one share of General Motors for $30 (and for our example we assume the ownership of General Motors has been divided into one billion equal pieces, or shares), then the implied price to purchase the entire company (all one billion shares) would be $30 billion. However, if at some point during the same year, General Motors shares could have been purchased for $60 each, that would indicate that the cost to purchase all of General Motors would be $60 billion.
So I ask the question again: How can this be? Can the value of General Motors, the largest car manufacturer in North America, change that much within the same year? Can a company that large be worth $30 billion one day and then a few months later be worth $60 billion? Are they selling twice as many cars, making twice as much money, or doing something drastically different in their business to justify such a large change in value? Of course, it’s possible. But what about the big price changes in IBM, Abercrombie & Fitch, and General Electric? Does something happen each and every year to account for large changes in the value of most companies?
Remember, every year the results are the same. For pretty much any company that my students name, the range of high and low prices, over the course of only one year, is huge. Does this make sense? Well, to save the class time (and since my attention span is usually a matter of seconds), I usually blurt out the answer. No! It makes no sense that the values of most companies swing wildly from high to low, or low to high, during the course of each and every year. On the other hand, it seems pretty clear that the prices of the shares in most companies swing around wildly each and every year. All you have to do is look in the newspaper to see that that’s true.
So I ask my room full of smart, sophisticated students to try to explain why. Why do the prices of all these businesses move around so much each year if the values of their businesses can’t possibly change that much? Well, it’s a good question, so I generally let my students spend some time offering up complicated explanations and theories.
In fact, it’s such a good question that professors have developed whole fields of economic, mathematical, and social study to try to explain it. Even more incredible, most of this academic work has involved coming up with theories as to why something that clearly makes no sense actually makes sense. You have to be really smart to do that. So why do share prices move around so much every year when it seems clear that the values of the underlying businesses do not? Well, here’s how I explain it to my students : Who knows and who cares?
Maybe people go nuts a lot. Maybe it’s hard to predict future earnings. Maybe it’s hard to decide what a fair rate of return on your purchase price is. Maybe people get a little depressed sometimes and don’t want to pay a lot for stuff. Maybe people get excited sometimes and are willing to pay a lot. So maybe people simply justify high prices by making high estimates for future earnings when they are happy and justify low prices by making low estimates when they are sad.
But like I said, maybe people just go nuts a lot (still my favorite). The truth is that I don’t really have to know why people are willing to buy and sell shares of most companies at wildly different prices over very short periods of time. I just have to know that they do! Why is this helpful?
Let’s think about that.
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