ELi5 : Why does the stock of a company fluctuate when it is involved in a controversy?

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ELi5 : Why does the stock of a company fluctuate when it is involved in a controversy?

In: Economics

Lets say Company is like your friend and you think of him as a good person. One day you see him do something bad on purpose. You don’t think he is as good of a person as before

The stock value of a company is a representation of its current and future monetary value.

A controversy lowers that value because people lose trust in the brand, the company may have to pay fines or the government may place restrictions on the company or industry as a whole.

There is obviously other elements, but mostly a company’s stock is based on speculation. It is based on how well you think it will do in the future. Controversy makes people lose confidence in a stock, they sell, people buy, the price can change a lot in a short amount of time.

Usually it’ll cause people to sell shares because they don’t want to be associated with the company or they think the bad PR will hurt sales. When enough people sell shares, the price of a share goes down because there’s less demand. Some people will see the price go down and think “this company will probably just bounce back from this, no one cares about bad PR for longer than a day.” So, they’ll buy the dip, hoping to make a lot when it bounces back, and when enough people buy shares, the price goes up due to demand.

It’s important to remember what a stock is. Its not just a piece of paper that people trade back and forth to get rich. It’s a fraction of ownership of a company.

Imagine that you own your own business. Just you, nobody else. This essentially makes you the “sole shareholder”. Let’s say that this business is a bakery.

One day you decide that you’ve done enough baking in your life. You want to sell the bakery and change your line of work. Now, whenever you sell anything you want a reasonable estimation of what it’s worth prior to getting into any negotiations, right? Well, how exactly do you calculate the value of an entire “business”?

You could sell the bakery based off the retail value of the space it occupies as well as the baking equipment and other “physical” things in your inventory. This essentially is basing the entire value of the business off the real things that it owns.

But is that the whole story? Is the bakery solely worth the stuff in it? What if your bakery has been profitable every month for years up to this point? Doesn’t that potential income represent real value? If your bakery has a good chance of generating income for any buyer, you would be cheating yourself if you sold the business for just the things inside it. So when you negotiate an actual dollar value with a potential buyer for your business TODAY you need to keep in mind the money making potential of that business TOMORROW.

In the most basic sense that’s what happens when stocks are traded on the market. The market compromises millions of traders exchanging fractional pieces of ownership of companies. As an aggregate it is trying to figure out what the future value of these companies are.

In that light, any controversies a company is involved in, say for example the BP Gulf Oil spill, represent a new negative piece of information about that companies potential. Obviously the market can’t predict the future so when unexpected events occur it needs to adjust its expectations. This adjustment takes time as people negotiate back and forth, find out more information, and finally settle on what they think the long term impact of this controversy will be on the company’s prospects.

If you want to read more about this in very simple and easy to understand terms, I would recommend “A Random Walk Down Wall Street” by Burton G. Malkiel.

Because a company involved in controversy might lose customers, which means they will make less money, making the company less valuable.

Controversy could cost them customers, thus impact revenues and profits; could open them to lawsuits, fines, etc. that could cost company and hurt profits.

Stock Prices reflect what people think they can sell the stock for, not any underlying value in the company. This means that they are much more of a product of human psychology than economics. During a controversy, there is a lot of uncertainty in what people think they can get for the company’s stock, resulting in fluctuations in the stock price, even if the company’s operations have not changed at all.

The value of a stock is based on people perceptions of that value. When brand new news becomes available (either good or bad news) then this perception changes, and with it the price will change. But right as it’s happening not everyone will know the news, which causes different opinions on the current value, leading to some people thinking the price should be higher and others thinking it should be lower, which causes it to fluctuate in a flurry as all the people that think it should be higher start to buy, and all the people thinking it should be lower start to sell. After the initial shock you still have fluctuations as people try to understand the full impact of the news. As more analysis and more information becomes available eventually a new fairly stable consensus point will be reached, and the stock price will adjust to this new point.

For example, right as a company releases a quarterly report, it’s frequent that it contains some mixed information. So, for example, the company beats consensus estimates for the quarter, but gives mixed guidance for the next year. Everyone is in a rush to exploit this new information, but know one really knows exactly what it means until they can do some work making a full assessment, and the after hours price will jump all over the place. By the next morning a consensus might have formed about what all the news means and the opening price is actually quite different than the after hours price, another small flurry at open as things adjust, and then things stabilize again.