What Determines the Price of a Stock?

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If you aren’t experienced with investing or the stock market in general, you may not fully understand what the numbers on the stock market board which are constantly moving up and down are actually supposed to mean, let alone why they move in such a frequency.




Those numbers are actually the stock prices of publicly trading companies, and sometimes there are ticker symbols right next to the stock prices, which each individual company is assigned to.

But what exactly makes up those stock prices? Who essentially decides at which price level the stock is going to trade?

Let’s look at an example of how stock prices of public companies can significantly vary from one business to another.

As of July 2020, Facebook (FB) is currently trading at about $239 for one share, while Berkshire Hathaway class A stock (BRK.A) is priced at a staggering $273,000 per share.

Even if the stock prices of both businesses heavily deviate from each other, Facebook and Berkshire Hathaway as whole businesses do have very similar market value also called market capitalization.

This is due to the fact that Berkshire’s share count is substantially lower than Facebook’s number of shares.


Consequently, stock prices don’t tell anything about the general value of a business.


A stock price on itself just shows the current cost to acquire one single share of a company from the stock market, while multiplied with the number of shares outstanding, it makes up the total market capitalization, or in other words, the price to acquire the whole business from a market perspective.


»Learn more about the number of shares within a comany


For instance, let’s assume a company A currently represents a market capitalization of $150 million and has 2 million shares outstanding. By dividing the market cap. with the number of shares outstanding, we would come up with a stock price of $75.

As a result, one of the primary factors that control stock prices is the number of shares within a company that can change throughout time.


What Determines the Price of a Stock?


Supply and Demand

Within the stock market, there are two sides – the buyers and sellers. If you wanted to invest in a certain company, you would have to send a buy order through your broker with a certain price tag also called bid, to the stock exchange.

That buy order would be then matched with a sell order from someone who is willing to sell their shares of stock for a certain price called to ask. The most recent price at which buyers and sellers agree to trade reflects the current stock market price.

Just as the principles of demand and supply conclude when more and more investors are looking to buy shares of a certain company, the demand increases, leading to a stock price increase. On the other hand, when there are many more sellers who are trying to sell the shares than the number of buyers, stock prices are declining. 

The most important thing to understand about stock prices is simply the fact that stock prices always reflect the market’s opinion of what a business is worth, and not necessarily the true value of the business.

This allows stock prices to fluctuate in accordance with future expectations from investors. If investors especially favor a particular stock, its stock price is likely to go up, while other stocks that might come out of favor due to several different factors are likely to suffer from stock price decreases.


What Factors Affect Stock Price Assumptions?


So if the price of a stock heavily relies on the opinion about that stock’s worth from the investor’s perspective, what exactly influences those opinions?

Arguably the most important part of a company that investors focus on, are the earnings of the company. Increasing earnings within a business usually drive up stock prices over the long term since it makes up a strong sign to investors about the rising value and future positive outlook of the company. 

Many Investors use a common metric called the price-to-earnings ratio to gauge a stock’s price in relation to the underlying earnings of the company.

Pretty much everything ranging from problems within the business to certain economic activities can influence the current view of investors about the company.

For instance, a company that is currently operating within a dying industry would signalize many investors that the business is not likely to have a bright future outlook, leading shareholders to sell their stock and thus lead to a decrease in the stock price. 

Sometimes, stock prices will still be high, despite the current financials of the underlying business.

Oftentimes, this indicates that investors are willing to overpay for a business, as they believe that the business is about to grow substantially in the future, whereas companies that aren’t likely to grow rapidly will mostly trade at lower price multiples.

The results that follow expectations of future earnings can also lead to heavy stock price movements.

Companies usually report their recent earnings on a quarterly basis, and if the announced earnings don’t meet the expectations of investors, the company’s stock price usually suffers from that.

On the other hand, when companies exceed investor’s expectations with higher earnings than expected, causing the stock price to increase.


Are Stock Prices Predictable?


The general rule is the shorter the time frame, the more difficult it becomes to predict stock price movements. Trying to predict if a stock is going up or down within short time frames is rather considered as speculating and not real investing.

As a day trader, for example, you are rather challenging your luck by mostly relying on pure randomness, instead of common and logical sense. The odds for you to make consistent profits in the long term by speculating are low, as even the best stocks experts can’t predict how the future is going to look like. Because nobody can.  

Stock price movements are simply not fully predictable because they essentially reflect human behavior and decisions, which are also extremely difficult to predict, especially in the short term since we can not completely act with rational sense on every decision we make.

In order to understand why investing in the long-term would be a better idea, you could ask yourself the following question.

Do you think that the stock market will be going up or down tomorrow? If you’ve come to an answer, how confident are you with your prediction? You wouldn’t probably be so sure, as market prices could always fluctuate heavily, especially in uncertain times. 

On the other hand, if you ask yourself the question of how the stock market is going to look like in 20 years, you are most likely going to come up with a more confident conclusion. Most investors would expect the stock market to rise after 20 years, as markets have always risen over the very long term in past history.

Even if the future is always unclear and not completely predictable, we could certainly assume that chances for the stock market to turn out positive after two decades are higher than the chances for markets to close positive after one day.


Conclusion

The fundamental factor that determines a stock price is the law of suppy and demand. If more and more investors are willing to buy a stock, the demand for that stock rises and thus its share price.

The demand for a stock is heavily based on the underlying fundamentals of the company and its future prospects. In general, investors are willing to pay a higher premium for companies that are expected to grow at a faster paste than other businesses.

Furthermore, the price of a stock will also depend on the share count within a business. Companies that have a lower number of shares will have a more expensive stock than other companies that might even have similar market capitalization.

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Disclaimer

The information on this website is not intended as investment advice. Do not consider the information as individualized financial advice or advocation to buy and sell any finanical securities. 

Investing comes with inherit risks. Therefore, you should always consider seeking investment advice from a professional who is aware of your individual financial situation. You are responsible for your own investment research and decisions.

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