The magic of markets is that they aggregate information from lots of individual actors into prices. As such they are an amazing coordination mechanism that has done wonders for guiding economies. But prices are also noisy and especially so when it comes to assets and in particular to the share price of companies. This post is a reminder to focus on fundamentals and largely ignore short term swings in share price.
The price for pizza is determined by the demand and supply of pizza. Both of those are relatively easy to understand. On the supply side there are known ingredients and product processes which give you a cost curve for making pizza. On the demand side people’s taste in food is relatively stable over time and varies in fairly predictable ways with price: as it goes up the demand goes down. The interaction between supply and demand takes place in a market where neither buyers nor suppliers have market power. As a result the price for pizza is quite stable and good at allocating resources to the production of pizza.
Pretty much none of this is true for the price of shares. In the public markets both the supply and the demand for shares are the result of the expectations of buyers and sellers about the future performance of those shares. Those expectations in turn are influenced by changes in price. For instance, the price going up often leads to expectations of it going up further, increasing the demand and reducing the supply, thus further increasing, well, the price. The opposite is true when share prices start to go down. As a result share prices can be volatile both for individual stocks and even for the market as a whole.
The key point is that expectations change much faster than reality does and thus tend to vastly exaggerate any real changes that are taking place. This is doubly true because investors tend to have way more information about price movements (expectations) than they have about reality. As a reminder of all this here is a stock chart of a company that was clearly doomed:
What is the company? It happens to be Amazon, a company that today is trading at nearly $600 per share. And here is the chart that puts the earlier 1997-2001 chart in that larger perspective.
I am not saying anything about whether Amazon’s current valuation is too high or too low. Simply that the entire run up and subsequent crash during the dot com bubble was a super noisy measure of the reality of Amazon’s business – to the point of almost being irrelevant.
So whether you are running a tech company, working for one, or investing in one I highly recommend not reading too much into changes in share price. Focus instead on whether your company is making real progress. Adding users. Growing revenues. Shipping product. And ask whether you believe in the long term opportunity. If you do and there is real progress towards that opportunity that’s what really matters.
Later this week: A follow up on how share price can become reality through interactions with the financing of a company. This is especially pertinent to companies that are cash flow negative and require further equity financing.
