If you are new to the stock market, stock prices may seem strange or mysterious. They go up and down every day, often seemingly without any explanation. One day, your portfolio could be up 100% or more. Another day, it could be down 30-50%.
Unfortunately, there is no definitive answer to how stock prices are determined. Generally, a variety of factors impact stock prices, including supply and demand, the company’s overall financial health, earnings prospects, and market sentiment. Other factors include interest rates, inflation rates, and global economic conditions.
- Companies first offer their stocks to the public through an initial public offering (IPO).
- After a company IPOs, a combination of factors determines stock prices. The perceived value of a company will get based on things like its profitability, growth potential, leadership team, etc. Supply and demand will get affected by things like investor sentiment, economic conditions, and political events.
The Short Answer: It’s Complicated!
There’s a lot of speculation when it comes to what makes stock prices tick. Some people believe that they’re simply a reflection of a company’s current financial stability and future prospects. Others think that they’re manipulated by big banks and other institutional investors with a lot of money. But the truth is, no one really knows for sure how stock prices are determined.
How It All Starts
An initial public offering, also known as an IPO, is the first time a company offers its stock to the public. A company may decide to go public for many reasons, such as to fund operations, expand to new markets, or launch new products. When a company decides to go public, it files documents with the Securities and Exchange Commission (SEC). These documents include information about the company’s financial history and future plans.
The SEC reviews these documents and makes sure that all the information is accurate. Once their application gets approved, the company can start marketing its stock to potential investors. The price each share of stock gets sold at is set by investment banks the company hires to help with the IPO. The banks will determine the initial price based on the company’s value and the demand from institutional investors.
On IPO day, buyers can place orders for shares on secondary markets, either through their broker or on an exchange like the Nasdaq or New York Stock Exchange (NYSE). If there are more buyers than shares available, then those buyers will be placed in a queue according to how much they’re willing to pay per share. The highest bidders get their shares first, and so on until all of the shares get sold.
Understanding Market Capitalization
Market capitalization measures a company’s size and value and is calculated by multiplying a company’s shares outstanding by the current market price of one share. A company’s market cap first gets established through an IPO.
There are several factors to consider when assessing market cap:
- Number of shares outstanding: This measures how many shares are available for purchase on the open market. When companies issue more shares to fund their operations, they dilute everyone’s shareholder equity. On the flip side, if a company buys back shares, the price of your shares will go up. Companies with excess cash frequently do share buybacks to pump up their market value.
- Price per share: This measures how much investors are willing to pay for each share of stock.
- Liquidity: This refers to how easily investors can sell their shares. High liquidity means that there are many buyers and sellers in the market, while low liquidity means that there are few buyers and sellers in the market.
- Earning power: A high earnings power indicates that a company has strong profits and will likely be able to continue growing its business in the future.
When looking at all these factors together, you can get an idea of whether or not a particular stock may be undervalued or overvalued. Understanding what goes into calculating market cap will allow you to make more informed investment decisions.
The capital markets, or “Wall Street,” serve three main purposes:
- The Primary Market: If a business owner wants to start or expand their business, they can use the capital markets to connect with investors willing to invest in their company. There are two main ways for a business to raise capital either by issuing bonds or stocks. When a company issues bonds, they negotiate a loan deal with investors and agree on the terms and conditions. When a company issues stock, they sell partial ownership in the company in exchange for capital.
- The Secondary Market: Capital markets provide liquidity by facilitating a secondary market for existing owners of stocks and bonds to find other investors willing to buy their securities. Once a company IPOs, investors can trade these shares on various stock exchanges.
- Investment Professionals: Capital markets create opportunities for both institutions and individuals to invest on other people’s behalf for a fee. If you want to outsource your investment decisions, you can pay someone else to take care of your portfolio. That frees up your time to focus on other financial goals or your primary career instead of listening to company earnings or reading 10-K filings.
Supply and Demand
In any economic market, the law of supply and demand drives prices. When there is more demand for a product than the available supply, the price goes up. And when there is more supply than people are willing to pay for, the price goes down. This economic law applies to stocks, real estate, crypto, and other financial markets.
The reason that stock prices go up and down can get boiled down to this one principle: when people want something more (demand), it becomes more expensive; when they want less (supply), it becomes cheaper. When stocks are highly traded and have high volume, buyers and sellers on both sides are constantly bidding and asking for new prices.
For example, I invest heavily in tech and growth stocks because I believe in their long-term growth potential and competitiveness of their products and services. Other investors do as well, driving up demand for shares of each company. Alternatively, if I feel that a company doesn’t have a strong competitive advantage or has weak leadership, I am less likely to invest in their business.
Beyond supply and demand, other factors can impact a stock’s price, such as the company’s earnings, risk and rewards, and momentum.
What a company earns from its operations can be divided into two categories: primary and secondary earnings. Primary earnings come from the actual business activities of the company, while secondary earnings come from things like investments or selling assets. Dividends are payments made to a company’s investors from their earnings. They can be paid in cash or shares of stock quarterly or annually.
Generally speaking, if a company has strong earnings growth or pays high dividends relative to its share price, its stock will be in higher demand. And if a company has faced financial setbacks recently or lowered its dividend payouts, its shares will likely get sold at lower prices.
Risk and Rewards
A company’s stock price can be affected by the perceived risks and rewards of investing in the business. For example, blue-chip stocks such as AbbVie, Disney, AT&T, and Procter & Gamble, are more established and have been successful for a long time. So, they are less risky to invest in when compared to companies that recently went public, such as Coinbase, Toast, and Roblox all of which have fallen significantly below their IPO prices (as of September 2022).
When there is a lot of excitement around a particular company, investors will flock to buy their shares, which drives the share price higher and attracts even more investors. The momentum created continues to drive the price up as long as the excitement continues. But, this momentum can also work in the other direction. When investors expect the company to do poorly, that can create fear and encourage a sell-off, which pushes the price down.
Momentum can get created from company news, such as new leadership, upcoming product launches, mergers and acquisitions, scandals, etc. For example, when a company announces an acquisition, the share price of the company getting acquired usually goes up in anticipation.
It’s also worth noting that stock prices can be affected by external factors such as economic conditions or political instability. For example, if the economy is doing poorly, people will be less likely to invest in stocks since they see them as being riskier investments. Conversely, if there’s a bull market, investors may feel more confident investing their money into stocks.
For example, at the beginning of the pandemic, the stock market crashed ~30% in a single day. As investors regained confidence in the economy, the stock market gradually went back up and even reached all-time highs for a while.
The activity of whales, or investors with a lot of money, can also influence share prices. The concentration of wealth among a group of investors can increase price volatility, particularly if a whale moves a large number of shares all at once, which can put downward pressure on the stock price as everyone else tries to sell. For example, in March 2021, Virgin Galactic Chairman, Chamath Palihapitiya, sold roughly ~$213 million of Virgin Galactic stock as the price continued to fall.
Analyst ratings can also play a role in setting stock prices. When analysts give companies high marks (such as “buy”), this often leads investors to believe that these companies’ stocks will increase in value over time. Conversely, when analysts downgrade their rating on a particular security (such as moving from “buy” to “hold” or to “sell”), it can lead investors to believe that the stock may not perform as well moving forward.
Determining a Stock’s Worth
Warren Buffett, one of the world’s most successful investors, follows a simple strategy to determine a stock’s worth. He looks at the company’s “intrinsic value” and compares it to the current market price. If the stock is trading below its intrinsic value, then Buffett considers buying it.
This strategy accounts for all aspects of a company, not just its current performance. For example, if a company has strong fundamentals but is facing short-term headwinds (such as mounting debt), its stock may be undervalued. If the underlying business model remains strong, the real value should eventually catch up and surpass the initial purchase price. Conversely, if a company has weak fundamentals but is doing well financially, for now, its stock may be overvalued.
Predicting Changes in Stock Prices
There is no one definitive way to predict stock prices. However, there are several factors and methods that you can use to make informed decisions about where the market is heading:
- Fundamental analysis: Fundamental analysts looks at a company’s earnings and financial strength to determine if it is a worthwhile investment. That can include analyzing the company’s financial documents, leadership team, competitive advantage, market position, product and service offerings, etc.
- Technical analysis: Technical analysts use past statistical data and trends to predict future price movements, such as stock charts, support and resistance, VWAP, etc. This method gets commonly used among day traders who want to make quick profits from price action.
- Economic conditions: Investors may closely monitor economic news to find clues about the market direction. For example, investors may monitor unemployment rates, jobs reports, interest rates, inflation, etc.
- Political developments: Political decisions, such as new laws or disputes between countries, can impact stock prices. For example, the ongoing Russia-Ukraine war has significantly increased tensions and concerns over international order.
When I evaluate individual stocks, I consider all these factors to get a more holistic idea of what’s happening at different companies and the political and economic landscape. As a buy-and-hold investor, I need to understand what I am investing in and believe in its long-term potential since I will be holding these assets in my portfolio for years or decades.
The Bottom Line
Determining stock prices is a complex process that takes many factors into account. The most crucial piece in setting stock prices is the supply and demand for the particular security. Other factors considered include earnings, dividends, company trends, analyst ratings, and recent news stories about the company.
Frequently Asked Questions (FAQs)
How are IPO stock prices determined?
When a company decides to go public and offer its stock for sale to the general public, it is conducting an initial public offering (IPO). The initial stock price gets determined through negotiation between the company and its investment bankers based on their financials, experience, the value of comparable stocks, and sales skills.
Who actually sets the price of a stock?
A stock’s price gets set by the market, which means it is determined by the supply and demand for that particular stock. If more people want to buy a stock than sell it, the price increases. And if there are more sellers than buyers, the price decreases.
Why do individuals buy stock?
Some people buy a stock because they believe in the company and want to own a piece of it. Others buy stocks to save for their retirement or to make money if the stock goes up in value. Whatever the reason, there are many benefits to buying stocks.
When you buy stock in a company, you become a shareholder. That means you have a say in how it gets run, and you can profit from its success. If the company does well, your shares will go up in value, and you can sell them for a profit. You also get dividends.
Another benefit of owning stocks is that they are liquid assets. That means that they can get sold quickly if needed without having to wait long periods like with real estate or other investments, making them perfect for short-term investments or as part of an overall investment portfolio.
How do you predict stock prices?
Some investors use fundamental analysis, which looks at a company’s financial stability and outlook. Others use technical analysis, which looks at past trends in the market to try and predict future movements. Many people also use a combination of the two techniques.
Ultimately, predicting stock prices is an inexact science no one can say exactly how a particular stock will perform in the future. However, by using various analytical methods and paying close attention to market conditions, it is possible to make informed guesses.
Where can you check stock prices?
There are several places where you can check stock prices. One place to check is with the companies you are interested in investing in. Most companies have a website where you can find information about their stock, including price quotes.
The more obvious route is to visit financial websites like Yahoo! Finance or Google Finance to get up-to-date information on stocks. These websites provide real-time quotes, charts, and news stories about individual companies and entire markets. If you want to stay informed while on the go, there are also many apps available that offer stock quotes and news updates.