Why do the price of shares of a corporation fluctuate?
Shouldn't the price of a share be a mathematical equation? Without getting too complicated with the accounts that are within equity, why isn't the value of a company's shares Assets less Liabilities and Retained Earnings? Makes too much sense to me. That would make the stock market less of a doomsday device and place a greater importance on financial statements. (Disclaimer: I believe there should be greater weight placed on FS not only because I am a CPA, but because I believe FS are what should drive a company. Currently, EPS is basically pointless with the current market structure and volatility but gets all the attention.)
You’re suggesting that equity prices should not fluctuate based on free markets, but based on the fundamental performance of a company. Our entire economy, along with stock valuation, operates within the core concept of free markets and a society based on capitalism. This means that the forces of supply and demand determine price. Butter at the grocery store is not priced directly because of the quality of the butter. It’s priced based on the amount of people (demand) wanting to buy the butter. The quality of the butter influences that demand, but it does not directly determine price. The same is true in equity markets. A company’s financial quality (based on a fundamental analysis of the balance sheet and cash flow) will influence demand, but it’s the actual demand (or lack thereof) of shares that will directly affect daily prices.
It’s also important to understand how the concept of speculation plays a role in equity market prices. Buyers of stock certainly care about the financial fundamentals of a firm, but they might care even more about whether or not they anticipate the price of the stock to increase in the future. This expectation could be based on many factors, including firm innovation, anticipated sales growth, acquisitions, etc. As buyers enter the market because of these expectations, demand has increased, driving up the price of the shares. There are many, many other factors that could influence the decision making of buyers and sellers in all markets within the structure of our economy, each ultimately playing a role in prices. Our economy is simply not a system in which prices are solely fixed based on fundamental/mathematical factors. It’s also important to understand that the system isn’t without its flaws. Various forms of price manipulation—either illegal or legal—can affect the “freeness” of the market. However, creating a new system of prices based on a strict mathematical equation, whether via the generally accepted accounting principles or otherwise, would be nearly impossible to regulate and might not serve the needs of investors. The complexity of equity market prices is a key reason why investing is extremely difficult for any “do-it-yourself” investors, particularly investors unable to construct diversified portfolios that properly fit their needs.
The best way to answer this is: perceived future value. There are fundamental analysts that will tell you all the balance sheet and cash flow items are important and they are right, for the most part. That is a good assessment of the company's viability, but how investors and the market value a stock is what they think the value will be in the future. That's why there are low and high valuations. It is a subjective assessment after you look at the company's bottom line. Trends and other ancillary items play into the equation as well (interest rates).
Now with all that said, that's the secondary market and the market most people know. The IPO market is more inline with earnings and balance sheet items, but also a future value component, but more weighted on the former.
Hope that helps.