Devoted to understanding the basics and fundamentals of investing

I was visiting my friend Ray H last night.  Ray said I had never addressed why stocks are volatile and react to news so abruptly.  I gave an off the cuff response that stocks are volatile because they are risky.  I realized later that is circular.  So here goes Ray, my attempt to explain volatility.

What goes into the price of a stock?  Modern theory tells us that the current price of a stock is the discounted value of the wealth the company is expected to generate for shareholders in the future.  So to value a stock you need to know how much wealth the investors expect it to generate forever and what is the appropriate discount rate.

How much wealth the company can generate depends on market conditions in the economies it operates in, the company's ability to generate revenue in those economies, how successful the company is now and will be in controlling expenses, what changes governments make in regulation and taxation, the capital expenditures needed to maintain current levels and to grow going forward and probably many other factors.

The discount rate depends on the prevailing level of interest rates on government debt in each of the company's markets (the risk free rate) and how risky the company is perceived to be relative to the government and to the market. 

Let's use Embarq Corp (EQ) as an example.  They announced earnings today.  Embarq was spun off from Sprint Nextel and started trading independently on May 4, 2006.  Embarq is the fifth-largest US local-telephone service provider.  So the economy is the US.  Telecom is heavily regulated.  Revenue comes from land lines, wireless services, voicemail for mobile phone and land line subscribers, high-speed Internet lines, etc. 

Investors would have to estimate how many land lines Embarq would lose to competition and wireless, how many wireless subscribers they would pick up, how many new high-speed Internet lines they would add and how much the spin off would cost.  All of these are unknown so analysts make educated guesses based on what they see for the whole industry. 

Investors were not optimistic for the company and it had lost 6.2% from May 4 through the close of trading last night.  With the earnings announcement, investors get clarity on many of the critical factors and can improve their estimates of how the company is likely to perform in the future.  The price jumps or falls based on these new estimates.  Embarq did better than the market expected and its shares have risen $0.73 per share since the announcement.

So volatility is caused by the fact that prices are based on expectations of future events.  As factors affecting any of these events change, investor's future expectations change.  These expectations are discounted back to the present to come up with a fair value for the stock which is jumping around because the world is constantly changing.

Ray, I hope that clarifies things a bit.  Let me know if it doesn't.