How stock prices are determined can be a bit ambiguous to anyone not on the trading floor. As investors, though, it’s important to know why a stock is priced at what it is, and why it changes.
So, I’m here to clear up the confusion. By the end of this, you will not only know how stock prices are determined but also how to pick stocks to buy and when to do so based on their price.
There’s one key thing I hope you get out of this: The price of a company’s stock does not always equal its value.
Alright, the class is in session. Let’s begin.
Determining a company’s value is the first step to determining what its stock price should be. Determining a company’s value is also a key step in determining whether or not you should invest in that company. You can only invest in a company, however, if it is publicly traded on the stock exchange.
When a company decides to go public, shares of the company, which are stock, go on sale. Most often, this occurs through a process called an Initial Public Offering or IPO.
Before the IPO, though, an investment bank has to determine that the company is worthy of investing in. If the bank finds the company worthy of investment then it helps determine what the price of the company’s stock should be.
The bank determines the initial price based on the value of the company and by testing prices on brokers before the company’s IPO.
A company may decide to go public for a variety of reasons. The main reason is that it receives money from the initial sale of its stock. It can use this money to fund operations, projects, new products, etc. in order to grow and become more successful.
After the IPO, a company no longer receives money from sales of its stock, but it can leverage its stock price for a variety of uses such as attracting more investors.
While the initial price of a company’s stock is largely based on the company’s value as determined by the investment bank, the price is influenced by other factors once the company is available for purchase on the stock exchange. From here, the law of supply and demand takes over.
Supply and Demand
Stock prices are largely determined by supply and demand. If a lot of people want to own a piece of a company, the demand for that company’s stock will go up and the price will rise.
If few people want to own a piece of a company and a lot of people are selling their shares, then the supply of that company’s stock will rise, the demand will fall, and the stock price will go down.
Of course, many factors can influence the supply of a stock and the demand for it.
Net Income and Cash Flow
One factor that influences the demand for a company’s stock is its financial statements. Any publicly-traded company is required to make its financial records public.
This means that all current and potential investors in that company can be aware of how much money the company is making, if they are growing, and if they have enough cash to sustain operations for the long term.
These are all important metrics that determine a company’s value and stock price. When net income and free cash flow are positive and increasing, investors will be more likely to purchase the company’s stock, and demand will increase.
Risk and Payout
The risk and reward of investing in a company also affect its stock price.
For example, the risk of investing in an established company that has been around and successful for a long time is far lower than the risk of investing in a company that just went public, and so the stock price for established and successful companies will typically be higher than newer companies with shorter track records.
The reward of investing in a stock is the expected payout. If investors expect the price of a stock to rise exponentially, the potential return is great, driving the demand, and so the price of that stock higher.
Momentum is one of the most influential factors on stock price. When the excitement for a particular company is high, it attracts investors, which drives the stock price higher, which in turn attracts more investors.
This creates momentum, which can continue to drive the price higher if excitement continues. Momentum can also work the other way, though.
If large amounts of investors are selling off stock in a certain company, it creates fear that encourages even more investors to sell off stock, which drives the price down.
Company news such as new leadership, product launches, missteps, and acquisitions can all drive momentum. Smart investors know not to follow the swing of momentum. Instead, they sell when prices are driven high due to excitement, and buy when prices are driven low due to fear.
Events, like momentum, can have a dramatic impact on the price of a company’s stock. However, events generally affect the entire market or entire industries.
Examples of events that impact the market include wars, natural disasters, elections, and pandemics. You have probably seen how the Coronavirus has impacted certain sectors of the economy and the stock prices of those companies.
These events can provide incredible opportunities for investors who are ready for them and know how to invest during a recession.
Now that you know how stock prices are determined, you can learn how to differentiate between the true value of a company and its stock price so you can know how to pick your first stock and every stock after that.
Stock Price vs. Intrinsic Value
Remember what I told you at the start of this article? The price of a stock doesn’t always equal its true value.
A company’s stock price, also called its market value, is simply the price of that stock on any given day at any given time. As we talked about above, stock prices are volatile and can be influenced by a number of things.
A company’s intrinsic value, also called book value, however, is what the company is actually worth. It is the amount a shareholder would be entitled to receive, in theory, if the company was liquidated.
Stock price and intrinsic value are rarely the same. This is why it’s important to do your own research and due diligence before you purchase any stock.
The key to making great investments is to buy the stock at a price lower than its intrinsic value. This is how Rule #1 investors know how to pick stocks to buy.
While events, momentum, risk, and financials can all affect the price of a company’s stock on any given day, in the long run, markets tend to price stock properly.
When you do your own research to understand a company’s true value, you will know its proper price, which will help you buy and sell at the right times.
If a stock is priced well below its intrinsic value and it meets the Four Ms of investing, you can confidently invest in it knowing that it will increase in price over time and give you a good return on your investment.
Now that you can confidently say you know how stock prices are determined, you’re ready to start picking stocks! Grab my guide to How To Pick Stocks to take the next step.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.