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How Are Stock Prices Determined: The 4 Main Factors (2021)

Knowledge Crunch | Tuesday, September 14, 2021 5:07 PM GMT

When you buy a stock, you’re not simply buying a piece of paper. A stock is an ownership share in a company you’re buying into that company and its potential performance. When a person invests, they gain an opportunity to join in on its success or failures over the long haul. 

The value of a stock is made up of several factors, including the company’s ability to continue making a profit, its customer base, its financial structure, the economy, political and cultural trends, and how the company fits within the industry. Understanding that will go a long way toward helping you select stocks for your portfolio.



Table of Contents

What is the Market Cap & How It's Connected to the Price of the Share?

Factor #1: Market Conditions 

Factor #2: Earning Trends

Factor #3: Expectations

Factor #4: Emotion

Frequently Asked Questions (FAQs)

 

What is the Market Cap & How It's Connected to the Price of the Share?

 

Typically, companies are categorized in one of three broad groups based on their size — large-cap, midcap, and small-cap. Cap is short for market capitalization, which is the value of a company on the open market. To calculate a company's market capitalization, multiply its stock's current price by the total number of outstanding shares.

Market cap definitions can vary, so the following are general guidelines.

Large-cap - Market value of $10 billion or more; generally mature, well-known companies within established industries.

Midcap - Market value between $3 billion and $10 billion; typically established companies within industries experiencing or expected to experience rapid growth.

Small-cap - Market value of $3 billion or less; tend to be young companies that serve niche markets or emerging industries.

 

Example of a Share Price Valuation

For example, say Tesla stock is trading at $100 per share (unrealistic I know). This company requires a 5 per cent minimum rate of return (r) and currently pays a $2 dividend per share (D1), which is expected to increase by 3% annually (g). 

 

The intrinsic value (p) of the stock is calculated as: $2 / (0.05 - 0.03) = $100.

 

According to the Gordon Growth Model, the shares are correctly valued at their intrinsic level. If they were trading at, say $125 per share, they'd be overvalued by 25 per cent; if they were trading at $90, they'd be undervalued by $10 (and a buying opportunity to value investors who seek out such stocks). 

Let have a look at the type of factors: 

Factor #1: Market Conditions

Often, the stock price of the companies in the same industry will move in tandem with each other. This is because market conditions generally affect the companies in the same industry the same way. But sometimes, the stock price of a company will benefit from a piece of bad news for its competitor if the companies are competing for the same market.

 

 

The 2 Types of Capital Markets

Capital markets are where savers come to invest their capital in long term investments such as corporate debt, equity-backed securities, and government bonds. In other words, savers with capital come to invest and those who need capital come to borrow.

So businesses come to the capital markets in order to borrow money to finance a new infrastructure project they are undertaking; these are known as corporate bonds. Capital markets deal with long term debt that allows businesses and governments to secure capital to allow them to invest and provide public services. 

This is defined as anything over one year. Anything under one year or less is considered within the money markets where the money is far more liquid. Simply put, capital markets deal with long term debt such as stocks and bonds – whereby the capital is used for long term investments that expand the business and increase revenues. By contrast, the money market focuses on short-term debt that focuses on funding day to day activities – examples include deposits, collateral loans, acceptances, and bills of exchange. 

Capital markets are split into two categories the primary market, and the secondary market. The primary market is where businesses and governments go to get fresh capital. In other words, investors go there to lend out money with fresh new debt being issued. 

We then have the secondary market. This is essentially where old debt is traded. In other words, investors go to this market to exchange cash in return for debt that has already been issued. For instance, a hedge fund may go to the S&P 500 to buy stocks in Alphabet. The cash has already been invested in Alphabet with the hedge fund receiving stocks. In the secondary market, the equity (stocks) are sold again in return for cash.

 

Primary Markets

The primary market is the market for new shares or securities. A primary market is one in which a company issues new securities in exchange for cash from an investor (buyer). It deals with the trade of new issues of stocks and other securities sold to the investors. 

This market is sometimes called the new issues market. When investors purchase securities on the primary capital market, the company that offers the securities hires an underwriting firm to review it and create a prospectus outlining the price and other details of the securities to be issued. All issues on the primary market are subject to strict regulation. 

Companies file statements with the Securities and Exchange Commission (SEC) and other securities agencies and must wait until their filings are approved before they can go public. Small investors are often unable to buy securities on the primary market because the company and its investment bankers want to sell all of the available securities in a short amount of time to meet the required volume, and they must focus on marketing the sale to large investors who can buy more securities at once. Now let's look at secondary markets.

Secondary Markets

The secondary markets is where old debt or stocks are traded between investors. This contrasts with the primary market as the debt has already been issued. In essence, the debt is acting as real money. 

The value it has is the interest that is paid on it – so it acts as a passive source of revenue. Yet it is an illiquid asset in the fact that you have to sell it to buy goods and services in the economy. In turn, those who don’t need liquid capital will invest in the capital markets, whilst those who need money now will go to the secondary markets to sell their bonds and equities.

In the secondary capital markets, stocks are traded between investors through stock markets such as the London Stock Exchange, the Tokyo Stock Exchange, and the New York Stock Exchange among many others. Those who no longer want specific stocks sell them on the exchange. These are then ‘liquidated’. In other words, the seller now has cash instead. So those are the market conditions, let’s move on to the next topic of Earning trends.



Value investors believe that if a business is cheap compared to its intrinsic value, (as measured by its P/E ratio, in this case) the stock price may rise faster than that of others as the price comes back in line with the worth of the company.

A company's earnings are, quite simply, its profits. Take a company's revenue from selling something, subtract all the costs to produce that product, and, you have earnings. The details of accounting get a lot more complicated, but earnings always refer to how much money a company makes minus costs. Its many synonyms cause part of the confusion associated with earnings. The terms profit, net income, bottom line, and earnings all refer to the same thing.

Investors care about earnings because they ultimately drive stock prices. Strong earnings generally result in the stock price moving up (and vice versa). Sometimes a company with a rocketing stock price might not be making much money, but the rising price means that investors are hoping that the company will be profitable in the future. Of course, there are no guarantees that the company will fulfil investors' current expectations… Speaking of expectations, let's cover that too.



Factor #3: Expectations

The importance of expectations in the formation of the prices of stocks is beyond any doubt. It is also indisputable that investors’ expectations are not rational and that human beings often make mistakes that affect the decision-making process. 

You have millions of individuals offering differing opinions. Value investors will provide conservative estimates, growth investors will provide extreme estimates. No single person may be correct, but over time, the value will be recognized by the market.

The market expectations theory melds into the theory of efficient markets, which asserts that all market pricing already “knows” all of the commercial data that are known. The theory is that market efficiency causes existing market prices to reflect all relevant information at all times. 

Many commentators dismiss these and similar theories on the basis that human nature drives some market participants to withhold certain data for personal benefit and not for the well-being of others. Less cynical observareers point out that the theories cannot work in practice because many of us know so little about computer algorithms now significant players in market pricing. So those are the expectations, let’s move on to the next topic of emotions.

 

Factor #4: Emotion

Emotion is ever present in the stock market. Feelings do not discriminate among amateur and professional investors even though some people have more practice than others at keeping their emotions in check when making financial decisions. Nonetheless, positive and negative feelings do creep into the stock market and have an effect on stock market performance. These emotional extremes can trigger irrational decision-making that costs investors money, while in some cases joy can work to a stock's advantage.

Fear - There is an emotional pain that is associated with the financial loss that can cause investors to continue holding losing stocks out of fear. Emotional investing is not limited to the small investor, either. Indeed, investment professionals, such as traders, struggle with emotion -- including fear -- when navigating the stock market, too.

Bad Decisions - The stock market, by nature, is volatile. This means that stocks can exhibit extreme price swings that can make investors uneasy. Market volatility is blamed for causing investors to make ill-timed, emotional investment decisions instead of using logic, often leading to disappointing results.

Euphoria - Emotional investing can occur in an individual stock just as well as it can permeate the entire stock market. Euphoria is said to be the emotion that drove the price of technology stock Apple higher by about 75 per cent for several months.

Emotional attachment -  Technically known as an "anchoring bias," can cause investors to continue owning shares of doomed stocks. These feelings of attachment can develop for various reasons, such as placing too much emphasis on a single catalyst that led to the investment decision in the first place.

 

Now Over to You

Start looking at what we’ve mentioned in this blog and have a go at investing in stock yourself. Why not try what you’ve learnt from this blog and head over to ZuluTrade. We have traders that you can follow that invest in both and you may learn much more by copy trading.

We hope you enjoyed this edition of the knowledge crunch blog just as much as we enjoy writing them! Stay tuned for more and be sure to check out our other helpful blogs with advice and tips to reach your investment goals with ZuluTrade. 

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Disclaimer: The views expressed do not constitute investment or any other advice/recommendation/suggestion and are subject to change. Reliance upon information in this material is at the sole discretion of the reader. Opinions expressed in this article do not represent the opinion of ZuluTrade Social Trading Platform and do not constitute an offer or invitation to anyone to invest or trade. Every metric and the statistical number is a result of a past performance which does not constitute a promise or a certainty for a future one.

 

Frequently Asked Questions (FAQs)

Q1. Who decides the price of a share?

After a company goes public, and its shares start trading on a stock exchange, stock prices will change because of supply and demand. Just think of the stock market as a giant auction, with investors making bids for one another's stocks and offering to sell their own all at the same time. 

If there is a high demand for shares due to favourable factors, The price of a stock will increase. If the company's future growth potential doesn't look good, sellers of the stock can drive down its price.

Q2. Why is the price of a stock not always the same?

The majority of public companies opt to use stock splits at one point or another, increasing the number of shares outstanding by a certain factor (e.g., by a factor of two in a 2-1 split) and decreasing their share price by the same factor. By doing so, a company can keep its shares in a price range that doesn't look too expensive to investors. 

Most publicly traded companies keep their share price below $100. The reason is largely to maintain a price range, which ensures ample liquidity even as the company increases in value. If a company splits its shares every time it breaches the $100 mark, investors will always be able to buy the stock at a "cheap" price no matter how large the company becomes.

Q3. How do you know if a stock is overpriced or underpriced?

The first way is to check the P/E ratio of the company in the last 3-5 years and identify the median P/E. Then compare the current P/E with the median P/E. If the current P/E is more than the median P/E, you can say that the company is overvalued. If the current P/E is less than the median P/E, you can say that the company is undervalued.

Although the P/E ratio is the most popular and widely used ratio to gauge the valuation of a company, there can be instances where the P/E ratio doesn’t work. This is where the PEG ratio comes in. It is calculated as PE divided by its future earnings growth.

Q4. Which factors affect the share prices indirectly?

The following factors are as follows:

  1. Interest rates 
  2. Changes in economic policies 
  3. Inflation
  4. Deflation 
  5. Market sentiment 
  6. Industry trades 
  7. Global fluctuations 
  8. Natural disasters
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