The Impact of News of Expected Returns

The Value of a Company

The words stock and equity are used interchangeably because a stock reflects a piece of ownership in a company. Investors generally buy stocks for two reasons: because they expect the company to grow its product and market share over time (growth) or because they feel the company is undervalued based on its current stock price. Analysts may research a stock from a fundamental or a technical lens.

Fundamental analysis involves analyzing a company's financial statements and health, its management and competitive advantages, and its competitors and markets. Technical analysts study the patterns and price fluctuations and attempt to forecast the direction of prices by studying past market data, primarily price and volume.

A stock's price is essentially determined by the buying and selling decisions of fundamental and technical analysts, who often manage large sums of money and have access to broad pools of data. Some stocks tend to fluctuate more than others daily, and the metric called beta describes the variance of a stock's day-to-day price. Stocks that tend to experience larger swings have higher beta values and expose owners to more specific risks.

For a company to be publicly traded on an exchange, it must comply with the regulations of that exchange board (NYSE or NASDAQ). Public investors are entitled to complete, accurate, and timely financial information about their investments. Companies generally announce updated financial figures every quarter. These figures include their current revenues, expenses, and profits, and investors use this information to assess the company's financial health. For most established companies, these reports are consistent and predictable and barely affect a stock's price. Macy's may announce higher profits in Quarter 4 than in Quarter 3, but its price might not move because analysts expected that Christmas would bring additional sales based on past data.

When a company announces its earnings as higher or lower than expected, the stock may experience a sudden shift in value. A higher-than-expected profit may come from increased revenues or decreased expenses. If a growing company announces higher-than-expected profits because of decreased expenses, it signals to investors that the company has found a cheaper way to produce its goods. That could in turn affect the expected returns of a competitor's stock, either positively or negatively, depending on how analysts forecast the effect.

The announcement of higher-than-expected sales from Ford could affect its stock price significantly, and it could set into motion a chain of events. If analysts believe the trend is based on a shift away from public transportation, it could raise the price of GM, Toyota, and maybe even Chevron. Suppose Nvidia, a company that produces smartphone microprocessors, announces higher-than-expected profits on reduced production costs. In that case, it might not only cause their stock to spike, but it could lead to a decrease in the price of the stock of their primary competition, Intel.

In general, fluctuations in one stock often lead to fluctuations in another stock. There are times when the markets are relatively stable and those when they are relatively volatile. Consider the image below. The correlation of 0.769 suggests that the volatility of the stock market in one month is very highly correlated to that in the previous month.

Volatility Begets Volatility Data shown is from the period of Jan. 1990-Sep. 2009. Volatility is measured as the standard deviation of S&P 500 one-day returns over a month's period.