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