Have you ever noticed how some stocks seem to soar for months on little or no news while other stocks can receive ongoing great news and hardly move higher at all? Today, we will review the important role of supply and demand in the stock market. More specifically, we'll concentrate on a very useful ratio for comparing the supply and demand - it is called the "turnover ratio" or TRO.
Before we discuss the TRO, let's quickly review the basics. The markets are driven by supply and demand. What really makes a stock price rise? How about "more buyers than sellers at a specific price level." On the other hand, if there are more sellers than buyers, then the price will quickly adjust down to the point where the buyers and sellers meet at an agreeable price. If there aren't sufficient sellers, the price will rise. So how can one go about comparing the supply vs. the demand of a particular stock? First let's define the elements needed to come up with this comparison.
In researching any stock you will often find the daily average volume and various share-related items, one of which is "float." You can get the information from a number of sites, but below is the site we will use for our discussion.
Go to Yahoo! Finance at http://finance.yahoo.com/? and input a stock symbol to retrieve a quote. After receiving the quote click on "Key Statistics." The following will take you directly to the statistics for eBay (EBAY): http://finance.yahoo.com/q/ks?s=ebay
Find the "Share Statistics" (right hand column) and locate these two items:
1) Daily Volume
Though most sites only give one Daily Volume figure, Yahoo! provides two averaged over different time periods (3 months or 10 days.) We recommend using the 10-day average as it will reflect more current trading activity.
Next turn to "Float" which represents the number of shares outstanding (or all the shares there are for that company) minus what is owned by insiders (people in the company, like the CEO, COO, CFO, President, Vice Presidents, etc.) and what the company is holding back (treasury stock). In a nutshell, associate the float with the supply of shares available to be traded at any given time by the public.
Now having defined the elements, the "turnover ratio," or TRO, is "the average daily volume divided by the float." Consider the following:
If the float is very large relative to the average volume (lots of shares out there to be bought and sold in relationship to the average volume) we would see a low turnover rate and thus an onrush of buyers would not move the price much. However, if the float is low relative to the average volume (a lot of people wanting very few available shares,) a sudden rush of buyers could move the price of a stock dramatically.
Let's take a look at a couple of examples. The first one is the widely held GE stock. Go to http://finance.yahoo.com/q/ks?s=ge and find the following information:
Daily Volume (10-day avg) 16.2M and Float is 9.92B
*Note that "B" is for billion, "M" is for million and "K" is for thousand. This can make a lot of difference in your calculations! If you find that the statistics are in two different "denominations" you must first convert one of the numbers into the same denomination as the other. We prefer millions, as it what you will find most often.
With this in mind we will now calculate the TRO for GE:
Daily Volume (10-day avg) of 16.2M divided by 9920M of Float = 0.16%
What significance is this? It means that only 0.16% of the total outstanding shares owned by investors are traded on average per day.
In contrast, let's take a look at Sohu.com (SOHU) by going to http://biz.yahoo.com/p/S/SOHU.html
Daily Volume (10-day avg) of 3.78M divided by 12.3M of Float = 30.7%
Wow, what a difference! 307 out of every 1,000 shares of SOHU have changed hands every day over the last ten days, compared to only about 16 of every 1,000 shares of GE. Higher TRO translates into bigger price swings.
Understand that TRO is simply a relative measure of the supply and demand relationship which tells us how volatile a stock will trade given an imbalance in supply or demand either to the up or downside. During strong up trends, we would gravitate towards high TRO stocks. During choppy times, lower TRO stocks will keep the Alka Seltzer in the medicine cabinet.
Case in point, from 8/1/03 - 8/20/03 SOHU traded as high as 39.52 and as low as 30.75. During that same time period GE hit a high of 29.62 and a low of 27.18. Also look at the daily Average True Range (ATR*) and how much more dramatic price movement can be in SOHU (2.62) compared to GE (0.69). The higher the turnover, the more volatile the stock - and the greater potential for larger swings in price (both up and down!).
In summary - turnover shouldn't be used to make a decision on whether to invest in any particular stock. Rather, it should be used to quantify the relative supply and demand and how much risk/reward there may be as a result of a change in trading volume, market conditions or significant news.
*ATR is found in RightLine Charts under "Indicators."