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The stock price of a company listed on a stock exchange is a reasonable estimate of what the company would be worth in the future based on future cash estimates. Future cash flows are predicted using information about the company, the state of the sector it is in and the overall condition of the economy.
The fact that a company is carrying out illegal or unethical practices is usually something that comes as a surprise. As traders and investors are not aware of this fact until the news comes in, this is immediately factored into the price of the company's stock. As these activities usually lead to losses for the company, the cash flow estimates have to be revised downwards. As a result of this, the price of the company's stock falls when it is found that illegal or unethical activities are being carried out.
One of the benefits of a Free Market is that this can actually occur -- investors (and consumers, for that matter) effectively vote with dollars -- they willingly give their money to a company to invest in or purchase its products or services. If they perceive anything amiss, they are free to withdraw their investment, and cease purchasing its products. As others have pointed out, stock prices will fluctuate accordingly. Contrast this with an economic model where the market is regulated, and a business may stay in business because of a government sweetheart deal, despite its illegal and unethical practices.
The earlier answers are all strong. If my goal as a stock investor is to see a return on my investment, I would not want any company in which I invest to do anything illegal or unethical. Illegalities can be literally costly in terms of legal fees and financial awards; unethical conduct can be costly in terms of damage to the "brand name" and can also lead to profit-damaging boycotts, protests, etc.
In regards to unethical activities, I wonder how these affect stock price even if they are discovered. A mass sell-off will initially lower the price, but depending on how badly the company is represented in media, many stockholders might not sell for a long time, especially if they think they can force a settlement from the company in litigation for defrauding them of their investments. On the other hand, today we have the largest and most efficient information transmission system ever devised (The Internet -- also an amazing rumor-mill) so accurate information is both easier and harder to pin down as fact. Unethical activities are often not classified as such until someone complains or someone writes a negative article, so it may be that many companies are engaging in unethical activities openly without losing their stock value because no one yet thinks badly of them!
#5, I think you're trying to put the horse before the cart, so to speak. Of course the price of a given stock will decrease if more shares of that stock become available.
But the question that started this thread asked why prices fell when a company was discovered to be involved in unethical or illegal activities. If the company's wrong-doing isn't known, the stockholders presumably remain happy and retain their stock. Indeed, if the undercover activity is allowing the company to fix the market or otherwise enhance their business portfolio, the stockholders may be absolutely elated with the performance of their stock and may be rushing to purchase more as the value increases!
Great answers and insights, but I think there is an essential element missing. Everyone has addressed why people sell, but (and correct me if I'm wrong) when people sell off large portions of stock, the market becomes glutted with the stock. Then, because there is so much stock available, its value is diminished. Supply and demand, but don't forget there is more stock available, and that's why it becomes worth less.
Stock prices are based on pure supply and demand. People and companies buy and sell them out of feelings of confidence and fear. Since these are emotions (not always based on reality), the appearance of illegal or unethical behavior might lead to lawsuits, investigations and fines, which are NEVER good for stock prices. When investors get nervous, they sell. That's why prices go down.
The previous answer is very good on why stock falls if a company does illegal things. But what if it just does unethical (but still legal) things. In that case, its stock will fall if investors feel that the company's image will be harmed and it will lose market share for that reason. For example, if people feel a company is harming the environment (though not illegally) they may stop patronizing it. If investors feel this will happen, the stock price will go down.
You might want to consider asking these questions separately so they can be answered more fully. As there are so many questions, I will address the second question only.
Stock prices are supposed to show the stability and value of a company. A company that is doing well and isn't likely to go out of business will have a higher stock price. If a company is found to be participating in unethical or illegal activities, their stock prices fall because they are no longer stable. These types of activities lead to lengthy investigations or even arrests. People aren't likely to purchase goods or services from a company involved in illicit activities. The business then becomes unstable and their assets are called into question. The stock price of that company will fall because the company is no longer stable and people are no longer willing to invest in it.
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