How Speculation and Valuation Move the Prices of Every Stock

Man Doing Research at Desk
Analysts Considering Facts During Research. Lane Oatey

Two of the most important factors driving the prices of stocks are speculation and valuation. While any investment can be driven by either of these forces, their influence is generally coming from one or the other, rather than both.

By this, I mean one of these price drivers will take the lead, and typically eliminates any and all impact from the other. Think of it like a mode of transportation — you can go by air or by boat or by car, but you probably won't travel by a flying car, or a floating airplane.

Speculation:

Speculation is based on what an investment "could possibly do." Are they working on a cure for cancer, or searching for diamonds in their mine, or developing a car that runs on gravitational forces?  

If they are successful, they will be worth billions! At least, that's how investors are thinking, which is why they are buying aggressively, and driving the shares up many times in value. They generally feel the potential result will be so lucrative, that other factors are overlooked in favor of getting involved at any price.

When speculation takes over, everything else gets ignored — debt loads; non-existent revenue levels; operational losses; disappearing cash balances; bigger competitors; and other business downsides — to focus on potential, all-encompassing success. 

As investors keep buying at higher and higher prices, despite the fact that the company doesn't create the cure, or find the diamonds, or figure out the gravity car, speculation continues to push stock up again and again.

 And as investors see prices go up, they believe the company is getting closer to their goal, so they buy in even more, which pushes the shares even higher. 

Speculation, unlike valuation, can not be calculated because there are no rules — is that investment worth one penny, or $40? With true speculation, it is very hard, if not impossible, to put any quantifiable value on the investment.

 

Newer, smaller, and riskier companies are mainly driven by speculative forces. Penny stocks are driven by speculation, and so are unproven business models, and early-stage business concepts.

Valuation:  

Generally, as corporations move into the mature phase of their corporate lifecycle, their prices are based on valuation. By now, they have assets, and potentially earnings, plus sales and revenues, so they have "value."

When you can compare two companies to each other directly, it typically means that they must have quantifiable value. If Corporation A generates 45 cents in earnings, and Corporation B makes 90 cents, you will know the second company enjoys twice the profit result. This situation allows the potential investor or stock market analyst to define the value of the underlying companies, and as such know which represents a more compelling price.

IBM has value. Harley Davidson has value. Bank of America has value. These stocks are not trading based on speculation, but rather their prices move due to changes in their value.

The Shift:

In general, when companies are new and unproven, they can only exist through speculation. Once their business grows, and they achieve great-enough revenues to pay most of their bills, they will shift to a valuation-based price.



The shift from speculation to valuation may indicate that a company has "made it." Every speculative company should be hoping to achieve the jump to valuation.

However, this move can be chaotic, and very often results in shares take a serious tumble. This happens frequently, and in many cases can be quite extreme.

What happens is that, in most cases at least, the earlier forces of speculation push the shares well above appropriate prices. Maybe they are "worth" $2, but speculators were buying the stock all the way up to $24.

Then, as the forces of speculation wane, and investors start shifting their focus towards what the stock is actually worth (which is based on data points like growth, market share, revenues, earnings, and assets), the share price suffers a major reset. In our example, you may see those $24 shares tumble towards $2 within a few months.

A great, real-world example of this was when Sirius and XM Satellite radio merged. There was so much speculative hope among investors, because the thinking was the upcoming merger would have numerous advantages as both competitors joined forces — administrative savings and lower marketing costs could help them corner the market. But when they eventually merged, this became a perfect example of buy the rumour, sell the fact.

The "fact" was that investors did not have the speculative "merger wind" at their backs any longer. There was no next, upcoming event in the near future to work these millions of speculators up into a frenzy, or stoke their buying mood. So people now needed to look at the actual financial position of the two companies (or more accurately, the fiscal house of the one combined entity).  

Here's a question for you: What do you get when you push two piles of mud together? Well, that would be a bigger pile of mud.  

Adding one company's half a billion dollars in debt, to another corporation's half a billion in debt, makes for a pretty ugly picture. Guess what happened to the shares once they combined?

Try to recognize which force is mainly controlling the prices of various shares you trade. Speculation can create greater, and quicker profits, but can also set you up for a sudden and significant decline. Valuation, on the other hand, is typically more sustainable, and may result in smaller gains, but at least those increases can be maintained for the long term.