Wow,
That's really interesting to see all those responses suggesting sentiment is the primary driver of a shares price. I hate to say it but I think that misses the point. I'm with TC on this one, its financial company returns that drive a share's price appreciation. I'll spell it out in layman's terms and then also explain where sentiment comes in:
The market capitalisation of a company is the net present value (NPV) of all its future cash flows. That might sound a bit complicated to the non-financial folk, but really it means that what a company is worth is equal to what it will earn over its lifetime discounted (NPV) to allow for the concept of time value of money.
Its then a simple matter to calculate the individual share price by just dividing the market cap by the number of issued shares for the company. As TC said, a share is part ownership of the company. So, if the company is now worth more, then your portion is worth more.
So, what makes shares rise in value? Simple: Improvements in the projections of future earnings for a company.
For example, the spot price of iron ore goes through the roof because China is industrialising. As a result, all of BHP's forward revenue projections just went up. As a result the net present value of all those future earnings is much higher resulting in a higher market cap valuation for the company. Divide that by the number of shares and every single BHP share just went up.
Sentiment plays a role because we're talking about "future" earnings. And the future is never set in stone. So, despite your best financial modelling, there's always a band of potential future earnings representing the optimistic and the pesimistic projections. This represents the "fair value" band for that stock based on current projections. A quick proxy for fair value is a stock's PER or Price to Earnings ratio. This allows every non-financial modeller to get a quick reckoner for where a stock sits with regards to its fair value. Sentiment kicks in when people think the earnings projections are either optimistic or pessimistic. Bullish sentiment pushes the share price to the top of the band based on projected future earnings, bearish to the bottom of the band. Sometimes markets go "bubble" when fair value flys out the window and people believe they know better than anyone else what a company's true value is. They discount the time honoured relationship between earnings and value and rate a shares price well above its actual true value. At the dotcom peak, even seasoned CEO's were saying things like "Don't buy stock in my company." Amazon, for example, was valued at a price which assumed they would sell every single book in the world. It all just went a bit crazy. Conversely, sometimes prices get way under-valued based on future earnings projections as happened on the ASX in the late 90's.
There's also a lag between earnings outlooks improving and share prices rising as the market grudgingly accepts the increased projections. I remember tipping BHP would run to $40 based on the spot price of commodites at the time, when they were still trading at $20. But it took a long time for that to happen as the market doesn't just buy-in to new earnings outlooks instantly. They need to see it happen and be convinced of the sustainability of the upside.
Hope that helps spell it out. Probably not worth a sticky, but definately some basic shares 1.0.1 that everyone should be aware of before trading stocks.
I'm sure others could add more detail around why markets sometimes get prices wrong given it is an "imperfect" market-place. But that's just fine tuning the definition. Fundamentally, its all about future earnings, and that's how I invest.
Cheers,
Michael.
