How Do Stock Prices Indicate Financial Health?
Investing in stock ties you directly to the fortunes of the company that you own stock in. However, stock prices are actually based on what other investors are willing to pay for your shares -- not necessarily on the financial health of the company. This means that there is a significant but indirect relationship between stock prices and financial health.
In general, a high stock price indicates good financial health and a low stock price indicates poor overall financial health. As a business grows and goes through hard times, its stock price usually rises and falls, respectively. Looking back over a company's historic stock price is one way to identify times of growth and times of poor financial health. This effect only occurs when investors incorporate their knowledge of the company's performance and financial health into their decisions to buy and sell shares.
Supply and Demand
When there is a consensus that a company's financial health is good, new investors may wish to buy into it and current investors may be unlikely to sell their shares. This creates a decrease in the available supply of shares and an increase in demand, driving prices up. The opposite can also happen: Poor financial health -- in the form of low earnings reports, for example -- can drive stock prices down.
Reading Into Stock Prices
While stock prices and financial health are related, all changes in stock price are not related to financial health. When a company's board of directors makes decisions about who to hire as CEO or whether to offer or cut a dividend, these decisions may make a stock price rise or fall, even though they do nothing to directly impact the financial health of the company. Stock prices also fluctuate based on changes in the industry in which a business operates and the global economy.
Investors and analysts use many tools to make judgments about a company's financial health. These include concrete measurements, such as earnings and market share, as well as less measurable factors: potential for growth and strength of leadership within the company. Many of these factors are the same ones used to measure financial health. Stock prices indicate how investors feel about all of these factors as a whole.