How are Stock Prices Determined
How stock prices are determined is not an exact science in reality, although we can in theory understand what causes prices to move up or down. You have probably learned that a great deal of money can be made trading stocks, and want to know more about it.
Naturally, you might want to try your hand at stock trading. Before you can make money trading stocks, however, you will need to understand how they work and what makes prices move up or down. Understanding how stock prices are determined will allow you to see opportunities when they arise and take advantage of them quickly.
So what causes one stock to rise and break records while another flounders? In this quick guide, we will discover the ins and outs of what factors impact stock prices.
How It All Begins - The IPO
In the beginning, when a company first decides to ‘go public’ or open up to outside investors, it must go through a rigorous process which can last years, ensuring that is suitable for public offering.
Eventually, when it has been determined that the company can be taken public, a team of expert analysts, exchange commissioners, investors, and investment bankers, will get together and try to determine an IPO, also known as an initial public offering.
The IPO is decided in a way which is far too complex to detail in this article, but it can involve bankers comparing the company in question to another company trading on the market, and will almost certainly involve an independent team of financial analysts who will attempt to determine the company’s health and overall value.
When this has been done and an IPO price has been reached, it will be up to the exchange to have the final say on whether or not the price is fair.
When it does, the company will be brought to market at that value. IPOs are often exciting times and some companies see their stock price initially skyrocket before later settling down and reaching an equilibrium.
When Market Forces Take Over
After the hype and excitement of the IPO, the stock price will be determined mostly by supply and demand.
Put simply, when more people demand a stock in a company, say because it is performing well and making killer profits, then the price rises, since there are only a set number of shares.
Likewise, when a company is underperforming, hemorrhaging money and failing to make the kinds of profits investors desire, the stock price falls as investors sell their shares, and fewer people want to buy them.
It’s supply and demand - plain and simple. This fundamental force will largely determine a stock price for the rest of its existence.
Buy orders are an offer to buy. Investors may believe that a company is going to perform well in and around earnings season, or at any time for that matter, and want to buy. This is also called the bid.
Sell orders are just the opposite. Think about it, if you held stock in company X, and you believed they were about to announce a loss, you would likely sell either before that loss was announced or shortly after it, since the stock will be worth less soon. This is also called the ask.
The price of a stock at any given moment is determined by finding the price at which the maximum number of shares will be traded. After this is determined, those transactions are carried out, and that price shows up in the market. This goes on all the way through trading hours and even into after trading hours.
Note: rapid price movements at the open can largely be attributed to buy/sell orders placed after the closing bell.
To find a company’s total overall value, just take the price of the stock and multiply it by the number of shares. If you compare just the share price of two firms, you won’t learn anything useful.
What Causes Stock Prices to Move?
In a perfectly rational world, stock prices would only move based on supply and demand.
However, the market is made up of human beings, and as may be obvious to anyone paying attention, we do not always behave rationally.
While earnings definitely affect the price of stock in any company, investor sentiment, expectation, and attitudes play a huge role.
For example - did you know it is possible for a stock’s price to move down if a company announces good earnings?
It does happen, and it is mostly because the investors expected the earnings to be even better, and are thus disappointed.
There have been many attempts to fully understand and explain what causes stock prices to move, but no single theory can cover everything.
It is best to take a holistic approach and realize that there are multiple factors at work all at the same time. We have outlined some of them below.
If things are currently going great at a company, or are likely to start going great in the future, that can have a huge impact on its stock price.
Likewise, if things are looking gloomy, that can have the exact opposite effect.
One of the key things investors research and look for to determine a company’s outlook is its growth potential.
To determine growth potential you could:
- Look at its financial information;
- Check how competitive it is in relation to other firms in the industry;
- Assess what markets it is thriving in and how it could expand geographically;
- Take a close look at management’s track record and current performance;
- Pay attention to company announcements like earnings, mergers, and acquisitions, product launches or recalls, lawsuits, etc.
No company is an island, and even a fantastic company operating in a distressed industry is going to suffer.
On the flip side, even a decent company operating in an industry which is growing quickly is likely to see some growth, since after all, all boats rise with the tide.
It is important to understand the industry any potential prospect is operating in. Nobody can be an expert in everything, but having a firm grip on the basics is essential.
Read trade magazines and expert analyst opinions on the industry and try to rely on your own assessments, rather than others.
The economy as a whole will largely determine how any industry performs.
When credit is flowing, employment is high, the political sphere is stable, and other fundamental indicators point to a bright future, then it is likely that all industries will continue to flourish. Likewise, the inverse is true.
The market in which the company is trading will also play a part.
Remember, it is all about supply and demand. People are less likely to buy stocks in companies operating in markets they think will underperform, and in fact are likely to sell off any stock they do own in such markets.
Likewise, if the overall sentiment about the market in question is bright and cheerful, with hope for lots of profits, the companies operating in that market are likely to face a high demand for stocks, causing prices to rise.
A huge hurricane in Florida could badly hurt insurance companies with a lot of liability in that area. The death of an important political leader or a coup will likely send several markets into a tailspin. An economic crisis will cause investors to panic and sell off stocks. A confrontation in the Middle East will send oil prices through the roof as concerns over supply take hold.
You get the picture, world events can have a huge impact on stock prices, causing prices to both rise and fall in tandem with them. Pay attention to these.
Most human beings follow the herd and this is as true in the financial markets as anywhere else.
It takes nerves of steel to hold a buy position that is falling rapidly when everyone around you is selling and forecasting doom and gloom for a given company or the economy as a whole.
Like it or not, we are all affected by herd instinct and this mass buying/selling plays a large role in stock prices.
That said, many of the greatest fortunes ever made have come as a result of holding out and not following the herd.
There is a great analogy for herd instinct and its effects on stock prices.
Think of the market as a character called Mr. Market. He’s a moody fellow, and when he moves, the markets move with him. He is subject to fits of fear, anxiety, and panic, causing prices to plummet, and is equally subject to fits of manic joy, glee, and optimism, causing prices to rise rapidly.
Pay attention to Mr. Market’s moods. If you don’t, you will soon find yourself in trouble.
How stock prices are determined isn’t an easy question to answer, and there will always be an element of mystery involved.
That said, if you take on board what has been outlined in this quick guide, you will be as well equipped as most to predict what might happen next with a company’s stock.
Remember, nobody has a crystal ball and nobody can say with any certainty what might happen next with any given stock. The above are merely observances based on what tends to happen given certain conditions.
If you pay attention, you will notice these same patterns yourself and be able to capitalize on tem.