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I searched for this question but I didn't get any convincing answer. What everyone says is that if a company does well (I assume this means the company has good returns on its projects) then people will want to get shares of that company because it's doing well. As such, the demand for stocks of that company will be high, therefore the price of the stock will go up.

What I don't like about that argument is: Why would people want to invest in a company because it does well? I mean suppose a company has bad returns on its projects, but let's say that shares of that company have high demand. Then, again by supply and demand, the price of the stock will go up. So why do people care if a company does well? Because, what I understood from searching the internet, is that the only thing that moves the price of a stock is simple supply and demand.

So I guess if a company does well, the demand increases, but I fail to see the reason. If a company does well, then it is expected that the total equity of the company will be increasing; however I don't know any relationship between equity of a company and value of a stock. So the whole story would only make sense if there is such a relationship. So is there? and why is it so?

TheGeometer
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  • Does my answer here answer your question: http://money.stackexchange.com/a/1395/366 ? I think the two questions are pretty similar (hence the "possible duplicate"). – GS - Apologise to Monica Apr 26 '15 at 21:24
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    This answer might answer your question, although this question is not a duplicate of that one. – Ben Miller Apr 27 '15 at 01:10
  • Stocks go up because companies perform well...or sometimes, given the exact same results, they go down. They go up because investors are confident; and sometimes investors are irrationally confident. And sometimes they're not. And sometimes stocks go down because the company did really well, but "analysts" (note the first four letters of that word) had predicted they'd do even better. Sometimes stocks go down because the weather is bad; and sometimes they go up (same reason). So, stocks go up and stocks go down - and your guess is as good as mine as to when, or why, or which direction. :-) – Bob Jarvis - Слава Україні Aug 24 '15 at 17:15

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The value of a stock ultimately is related to the valuation of a corporation. As part of the valuation, you can estimate the cash flows (discounted to present time) of the expected cash flows from owning a share. This stock value is the so-called "fundamental" value of a stock. What you are really asking is, how is the stock's market price and the fundamental value related? And by asking this, you have implicitly assumed they are not the same.

The reason that the fundamental value and market price can diverge is that simply, most shareholders will not continue holding the stock for the lifespan of a company (indeed some companies have been around for centuries). This means that without dividends or buybacks or liquidations or mergers/acquisitions, a typical shareholder cannot reasonably expect to recoup their share of the company's equity. In this case, the chief price driver is the aggregate expectation of buyers and sellers in the marketplace, not fundamental evaluation of the company's balance sheet.

Now obviously some expectations are based on fundamentals and expert opinions can differ, but even when all the experts agree roughly on the numbers, it may be that the market price is quite a ways away from their estimates. An interesting example is given in this survey of behavioral finance. It concerns Palm, a wholly-owned subsidiary of 3Com. When Palm went public, its shares went for such a high price, they were significantly higher than 3Com's shares. This mispricing persisted for several weeks.

Note that this facet of pricing is often given short shrift in standard explanations of the stock market. It seems despite decades of academic research (and Nobel prizes being handed out to behavioral economists), the knowledge has been slow to trickle down to laymen, although any observant person will realize something is amiss with the standard explanations. For example, before 2012, the last time Apple paid out dividends was 1995. Are we really to believe that people were pumping up Apple's stock price from 1995 to 2012 because they were waiting for dividends, or hoping for a merger or liquidation? It doesn't seem plausible to me, especially since after Apple announced dividends that year, Apple stock ended up taking a deep dive, despite Wall Street analysts stating the company was doing better than ever. That the stock price reflects expectations of the future cash flows from the stock is a thinly-disguised form of the Efficient Market Hypothesis (EMH), and there's a lot of evidence contrary to the EMH (see references in the previously-linked survey). If you believe what happened in Apple's case was just a rational re-evaluation of Apple stock, then I think you must be a hard-core EMH advocate.

Basically (and this is elaborated at length in the survey above), fundamentals and market pricing can become decoupled. This is because there are frictions in the marketplace making it difficult for people to take advantage of the mispricing. In some cases, this can go on for extended periods of time, possibly even years. Part of the friction is caused by strong beliefs by market participants which can often shift pressure to supply or demand. Two popular sayings on Wall Street are, "It doesn't matter if you're right. You have to be right at the right time." and "It doesn't matter if you're right, if the market disagrees with you." They suggest that you can make the right decision with where to put your money, but being "right" isn't what drives prices. The market does what it does, and it's subject to the whims of its participants.

Chan-Ho Suh
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    Benjamin Graham put it succinctly: "In the short run, the market is a voting machine but in the long run, it is a weighing machine." Interesting examples, but multiple anecdotes do not make evidence. Outliers will outlie. What is the aggregate behaviour of security prices w.r.t. profitability, over the long run? – Chris W. Rea Apr 28 '15 at 17:56
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    Hi Chris, citations to the academic studies are given in the linked survey paper by Barberis and Thaler. An interesting example they give in section 2.3.2 is on stocks that jump in price when they are added to the S&P 500. – Chan-Ho Suh Apr 28 '15 at 18:54
  • One component of the value of stocks appears to be subjective - the value of the stock is composed of the (EMH) valuation of the present value of the expected future return on earnings. And a second component is a subjective valuation of the ability of the company to continue (or improve) performance. But there seems to also be an iteratively subjective component - what an investor thinks another investor thinks yet another investor thinks will happen - the predictive component. And that is the subjective part that deflects stock price from actual valuation. – ChuckCottrill Apr 29 '15 at 01:30
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The same applies if you were looking for a business to buy: would you pay more for a business that is doing well making increasing profits year after year, or for a business that is not doing so well and is losing money.

A share in a company is basically a small part of a company which a shareholder can own. So would you rather own a part of a company that is increasing profits year after year or one that is continuously losing money?

Someone would buy shares in a company in order to make a better return than they could make elsewhere. They can make a profit through two ways: first, a share of the company's profits through dividends, and second capital gains from the price of the shares going up.

Why does the price of the shares go up over the long term when a company does well and increases profits? Because when a company increases profits they are making more and more money which increases the net worth of the company. More investors would prefer to buy shares in a company that makes increasing profits because this will increase the net worth of the company, and in turn will drive the share price higher over the long term. A company's increase in profits creates higher demand for the company's shares.

Think about it, if interest rates are so low like they are now, where it is hard to get a return higher than inflation, why wouldn't investors then search for higher returns in good performing companies in the stock market? More investors' and traders' wanting some of the pie, creates higher demand for good performing stocks driving the share price higher. The demand for these companies is there primarily because the companies are increasing their profits and net worth, so over the long term the share price will increase in-line with the net worth. Over the short to medium term other factors can also affect the share price, sometime opposite to how the company is actually performing; however this is a whole different answer to a whole different question.

Victor
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    This explanation is pretty standard, but it is circular. You say: "... this will increase the net worth of the company and in turn will drive the share price higher over the long term." But that does not explain why an increase in the net worth of a company will drive the share price higher. In principle, there is no reason why people would buy the shares of a hugely profitable company unless owning the shares guarantees them a share of those profits. It is true that in practice they often do share in the profits, but the question is asking why, which your answer does not explain. – BrenBarn Apr 27 '15 at 00:11
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    @BrenBarn - what? "there is no reason why people would buy the shares of a hugely profitable company unless owning the shares guarantees them a share of those profits." Nothing is guaranteed, except taxes and death. The reason, as I explained, is because investors and other market participants are after higher returns than putting their money in the bank, and most market participants understand that more profits for the company means potentially more profits for them as shareholders (either through dividends, capital gains or other return of capital). – Victor Apr 27 '15 at 07:46
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    Substitute what you like for "guarantee". The point is that the question is about why stock prices rise when the company does well. It is true that they do, so you're right that it makes sense for people to put money in because the stock probably will go up. But your answer amounts to saying "stocks go up when people buy them because they go up when people buy them", which doesn't really explain much. – BrenBarn Apr 27 '15 at 07:49
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    @BrenBarn - NO, if you read my answer properly you would understand that what I explained was that if a company makes higher profits it will increase its net worth. This means that the company is now worth more, so if the company keeps increasing its net worth over a ten year period then the share price will follow upwards. The increase in net worth of the company drives the demand for the company which drives up the share price. – Victor Apr 27 '15 at 08:22
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    Again, the question is why that is so. – BrenBarn Apr 27 '15 at 15:57
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    @BrenBarn, after reading the question, the answer and your comments, it seems you have a problem understanding things. The reason as has been stated many times by Victor is that people want higher returns, so they aim to invest in companies that do well and make alot of profits, because if the company is making alot of profits, they could also share in those profits as a shareholder and meet their goal of higher returns. This drives the demand for the stocks and thus the price up. –  Apr 27 '15 at 21:24
  • I think BrenBarn understands things perfectly well here. There is a feedback cycle where belief feeds belief, even in the absence of dividends, buybacks, etc. – Chan-Ho Suh Apr 28 '15 at 02:47
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    @MarkDoony: The question says: "I don't know any relationship between equity of a company and value of a stock. So the only way the whole story would make sense is that is there is such a relationship. So is there? and why is it so?" This answer and your comment simply re-assert such a relationship, without answering the crucial "why is it so" part. Again, I'm not denying that assertion; but the questioner wants an explanation of why shareholders can expect to share in profits, other than the "explanation" that everyone else shares that expectation so demand will drive up the share price. – BrenBarn Apr 28 '15 at 03:46
  • @BrenBarn Perhaps I should expand my answer, as people don't seem to appreciate it :) But the answer is really that the price and valuation can be quite decoupled. Plenty of historical examples in intro behavioral economics classes. The way I like to think of it is like futures trading, where you have a core group of people really interested in buying/selling the underlying, and everyone else is a speculator (and possibly leading to divergence of underlying spot and future price). – Chan-Ho Suh Apr 28 '15 at 14:29
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Prices can go up or down for a variety of reasons. If interest rates decline typically every stock goes up, and vice versa.

Ultimately, there are two main value-related factors to a price of a stock: the dividends the company may issue or the payoff in the event the company is bought by someone else. Any dividend paid will give concrete value to a stock. For example, imagine a company has shares selling at $1.00 and they announce that they will pay a dividend at the end of the year of $1.00 per share. If their claim is believable then the stock is practically FREE at $1.00 a share, so in all likelihood the stock will go up a lot, just on the basis of the dividend alone.

If a company is bought by another, they need to buy at least a majority of the shares, and in some cases all the shares. Since the price the buyer will be willing to pay for the company is related to its potential future income for the buyer, the more profitable the company is, the more a buyer will be willing to pay and hence the greater the value of the stock.

Five Bagger
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Supply and Demand, pure and simple! There are two basic forms of this - a change in the quantity demanded/supplied at any given price, and a true change in the amount of demand/supply itself. Please note that this can be distinct from the underlying change in the value of the company and/or its expected future cash flows, which are a function of both financial performance and future expectations.

If more people want the stock that are willing to sell it at a given price at a given point in time, sellers will begin to offer the stocks at higher prices until the market is no longer willing to bear the new price, and vice versa. This will reduce the quantity of stocks demanded by buyers until the quantity demanded and the quantity supplied once again reach an equilibrium, at which point a transaction occurs. Because people are motivated to buy and sell for different reasons at different times, and because people have different opinions on a constant flow of new information, prices change frequently. This is one of the reasons why executives of a recent IPO don't typically sell all of their stock at once. In addition to legal restrictions and the message this would send to the market, if they flooded the market with additional quantities of stock supplied, all else being equal, since there is no corresponding increase in the quantity demanded, the price would drop significantly.

Sometimes, the demand itself for a company's stock shifts. Unlike a simple change in price driven by quantity supplied versus quantity demanded, this is a more fundamental shift. For example, let's suppose that the current demand for rare earth metals is driven by their commercial applications in consumer electronics. Now if new devices are developed that no longer require these metals, the demand for them will fall, regardless of the actions of individual buyers and sellers in the market. Another example is when the "rules of the game" for an industry change dramatically.

Markets are behavioral. In this sense prices are most directly driven by human behavior, which hopefully is based on well-informed opinions and facts. This is why sometimes the price keeps going up when financial performance decreases, and why sometimes it does not rise even while performance is improving. This is also why some companies' stock continues to rise even when they lose huge sums of money year after year. The key to understanding these scenarios is the opinions and expectations that buyers and sellers have of that information, which is expressed in their market behavior.

JAGAnalyst
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Remember that shares represent votes at the shareholders' meeting.

If share price drops too far below the value of that percentage of the company, the company gets bought out and taken over. This tends to set a minimum share price derived from the company's current value.

The share price may rise above that baseline if people expect it to be worth more in the future, or drop s bit below if people expect awful news. That's why investment is called speculation.

If the price asked is too high to be justified by current guesses, nobody buys. That sets the upper limit at any given time.

Since some of this is guesswork, the market is not completely rational. Prices can drop after good news if they'd been inflated by the expectation of better news, for example.

In general, businesses which don't crash tend to grow. Hence the market as a whole generally trends upward if viewed on a long timescale. But there's a lot of noise on that curve; short term or single stocks are much harder to predict.

keshlam
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