While stocks are certificates of ownership in companies and their prices should reflect business values of their respective companies, stock market trading activities by various participants from long-term investors to short-term traders and speculators can also have their influences in settling stock prices. Although the value of a business does not change every day, the price of its stock fluctuates daily in market trading. Investor expectation, news events and any crowd psychological reactions could all contribute to the constant change in stock prices.
Business Intrinsic Value
Despite all the market noise, at the end of each trading day, traders and investors alike compare stock price to company earnings, and the price to earnings ratio has been the most staple valuation metric used in determining what and how much a stock's price should represent. One bit of investing advice that Warren Buffett, the investment oracle of Omaha, often gives is that owning a stock is owning a piece of business. In the book, "The Warren Buffett Way," the author explains that Buffett does not need a stock price to validate his business investments. In other words, the intrinsic value of a business is what its stock price ought to represent.
Investor Value Expectation
Stocks are priced based on both company past earnings results and investor expectation of company future performance. Investors are willing to pay higher prices if they predict that a stock will grow in value in the future. On the other hand, any negative outlook on a company's business by investors will likely lower its stock price. However, investor value expectations can be subjective and, to certain degree, stock price fluctuations reflect different valuations from different investors. There are so-called expectation investors, according to Expectation Investing, looking for stocks that are not priced to fully reflect a company's future performance.
News and Event Effects
Even though company fundamentals should dictate stock prices, stock market trading is very much information and event driven. While emerging news and events may or may not have changed a company's underlying business conditions, its stock price quickly adjusts to real time reports in anticipation of pending economic effects on the company. Newly released data on the economy, monetary policy announcements and corporate events, especially mergers and acquisitions, cause immediate reactions in the stock market and move stock prices accordingly.
Market Crowd Greed and Fear
When trading in real time, stock prices represent what the buyer is willing to pay and the seller is willing to take. In a bull market, stock prices continue to rise and the crowd becomes greedy, pushing stocks further up. In a bear market, stock prices keep falling and the crowd grows into fear, forcing stocks further down. With momentum trading being a popular trading strategy, it is not uncommon that traders judge stock prices out of greed and fear in a fast-moving market environment.
Stock Price Distortion
Amid all the different factors that affect stock prices, the market can overvalue or undervalue stocks along the way. In general, stocks trade in one of three price patterns: uptrend, downtrend and in range. For example, when a stock retreats from a brief uptrend and starts range trading for an extended period of time, the stock likely was overvalued on the way up, which could have been driven by investors' overly high expectations, positive news events or crowd over-enthusiasm. Always be aware of potential stock price distortion when analyzing what stock prices represent.