Should Shake Shack Owners Expect Continued Volatility?

Since going public in January of this year, Shake Shack shares could seemingly make a case for getting the next amusement park thrill ride named after them. Overall, shares are trading up over 60% since their debut, but in recent weeks shares have seen wild gyrations up and down. Some days have even seen 10% or greater intra-day movements in price.

While market volatility might excite day-traders, Foolish investors should consider what's driving the steep changes and how it impacts their portfolios. With that in mind, let's take a look at what's fueling the highs and lows of Shake Shack's stock and what it means for investors.

Shake Shack in Union Station, DC. Source: Shake Shack.

The problem of supply and demandIn the long term, share prices reflect fundamentals of the company (i.e., business growth, value, profitability, etc.). Short-term price fluctuations can be difficult to measure, however, as supply and demand for shares on the market of a given company can dramatically affect value. We can use Shake Shack as an example of this concept.

Let's first consider demand and what's driving investor interest for shares of Shake Shack. In the quarterly earnings report for quarter ending Apr. 1, 2015, Shake Shack reported a 56% year-over-year quarterly revenue increase. The net loss for the quarter was $12.7 million, but noted in the report was the fact that this included expenses of $13.2 million associated with the initial public offering just a few months prior. When accounting for this, adjusted earnings are actually positive at $0.04 per share. With a solid pipeline of new Shack openings, same store sales growth, and profitable operating margins, Shake Shack appears to be a promising new competitor in the fast-casual restaurant landscape, creating a demand for its shares.

What about supply? To understand where shares are coming from, we need to understand what "shares outstanding" and the "float" mean. Shares outstanding are the total number of shares a company has issued and sold to investors, including shares available to the public, as well as the restricted shares that are regulated by special permissions. This is different from the float, or the actual number of shares available to be freely traded on the market without restrictions. Naturally, share float will be smaller than shares outstanding, as some shares do not trade freely on the open market.

Now, let's put this in the context of Shake Shack's shares. Currently, the company has just over 12 million shares outstanding and 5.9 million shares in float.When you consider that, for the last few months, an average of almost a million shares change hands every day, and that the share float to shares outstanding ratio is almost 50%, we can conclude that there is a very small supply of Shake Shack shares available for trading. The conclusion? With high demand and low supply, Shake Shack shares will continue to have above average volatility and the large daily price swings should continue. (Conversely,a drop in demand for shares can make for quick drops in value in share prices as sellers can have a difficult time finding buyers for their stock.)

Compounding the issue at hand is Shake Shack's short float, which is a measure of how many shares of the company are being short sold (short selling a company is a bet that value will drop). Currently, that number is at 2.2 million shares, or 37% of all shares available for public trading.With such a high percentage of shares being sold short, it is possible that a short squeeze could occur. Such a situation would drive up demand as short sellers attempt to buy back shares to cover their positions and cause volatility to resume.

One last important point to note is that Shake Shack's 180 day lock-up provision (the period of time in which certain shares cannot be sold) ends on July 29th.This means that the 5.9 million shares in float stands to increase after this date, as certain institutional investors will be able to sell their interests to the public. This increase in supply could also add to the volatility that investors have been experiencing recently.

Takeaways for investorsCurrent owners and those pondering a purchase for the long haul should be aware that, as a closely held company with a small share float, Shake Shack is susceptible to steep changes in valuation. Just as the stock has run up more than 60% since January, it is also possible to see it come back down just as much or more in a very short stretch of time.

Shake Shack's roller coaster ride will likely continue to persist in the near-term, and for those contemplating buying a position in Shake Shack, I would recommend waiting until some of the volatility clears out. As a result of recent spikes in price to the upside, I feel that the company is currently over-valued and further downside correction could possibly persist.

Shake Shack can serve as a reminder for investors to consider how potential volatility could impact any holdings. Here are a few questions worth asking:

What is the potential short-term volatility of this investment? Can I stomach potentially large short-term drops in value and filter out short-term negativity impacting my purchase?
Am I really planning on holding this investment for the long term? Do I have the ability to do so?
What are the catalysts for growth that will push the stock higher over the long term? Can I stay focused on and assess these catalysts for progress?

Overall, investors should remember that short-term fluctuations can be difficult to predict and require an iron stomach.

The article Should Shake Shack Owners Expect Continued Volatility? originally appeared on Fool.com.

Nicholas Rossolillo has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.