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Why Does a Stock's Price Rise or Fall?

Introduction

Watching the ups and downs of stock prices can be enough to make you seasick. If you own stocks, you've undoubtedly followed their prices with a feeling of either satisfaction or disappointment, depending on how your investments have done. Short-term swings can be bewildering, and sometimes it seems as though stock prices follow a logic all their own. Even so, it is possible to break down stock performance in ways that help distinguish solid growth from inflated expectations.

Case Study in Rising Prices: Wal-Mart

A stock's price is determined by its fundamentals (how the company has actually performed) combined with its valuation (how much the market is willing to pay for that performance and the promise of future growth). Similarly, when a stock's price goes up, that rise comes from either (1) growth in the underlying business or (2) an increase in the stock's valuation, as the market becomes more optimistic about the company's future. As an illustration of these two drivers of stock performance, consider the history of Wal-Mart WMT.

In the 1970s and 1980s, Wal-Mart was the quintessential growth stock. It was profitable, with returns on equity consistently above 20%. Year after year, its revenue and earnings grew by more than 25%, often by more than 30%, as it opened new stores all over the country. As a result of this consistent growth, the annualized return of Wal-Mart's stock from 1970 to 1990 was about 35%. That's an impressive figure, but most of this return came from solid growth in revenue and earnings; Wal-Mart's valuations increased only modestly during this time.

In the early 1990s, this growth began to slow as the retailing giant started running out of places to expand in the United States. The number of new Wal-Mart stores barely inched up in 1994, after routinely