How are Stock Prices Determined?


Ever thought why do the stock prices fluctuate?

The answer is “Simple Economics – Demand & Supply”.

 

First of all, what are the stock prices?

The authentic definition of the share price is that it is the amount one has to pay to acquire the stock, an intangible asset. Initially, the price of a stock (a share of the company) is determined at the stage of IPO. The investment banker that the company hires, uses the financials of the company to conduct it’s valuation, finalizing the number of shares that can go public with an opening amount, the IPO Price. 

 

Why do they change?

When a company finally enters the secondary market of stocks, or in simpler terms, gets listed on a stock exchange, the prices are then influenced by the demand and supply of the stocks, which are in turn influenced by the performance of the company. 

When a company performs well, the demand for the stock increases, or when demand is more than the supply, the stock price increases. Similarly, if shareholders find the company financially unstable, they try to square off the position (sell the stock), which therefore increases the supply over demand, thus reducing the price.

 

Stock Price Trends

Almost everything in Technical Analysis, the stock market trends, analyses the historical market trends to predict the future of the market. The current performance of the company, future expectations, economic conditions, and many other factors collectively influence the demand and supply of the stock, creating different chart patterns of the stock. Technical Analysts use those chart trends to find the future trends of the stock.

There are different tools to track the trends of a particular stock or index, like Moving Average, Relative Strength Index, Rate of Change, etc. We will take a look at these in detail as well in some of our future blogs.

 

The Two Different Investors

Majorly the stock market has 2 types of investors, who according to the SEBI Guidelines are differentiated by the amount they invest in IPO or FPO. Any investor who applies or bids for shares worth upto Rs 2 lakh is known as Retail Investor, and anyone applying for shares worth higher value than Rs 2 lakh will be considered as Institutional Investors.

To understand the price and market trends better, we need to talk about Investors’ Psychology. Behavioural Finance proves that investors are irrational towards the market and do face errors and biases while taking the investment decision.

 

Retail Investors

The investor’s mood and sentiment cannot be ignored in predicting the market movements, the risk a particular investor can take is dependent on how opportunities are presented to him, and how he sees both the business he is going to invest in and the market in which business is operating.  

The following are the few biases that influence individual investors’ decisions:

  • Conservatism Bias  – It occurs when investors find a piece of particular news or concept difficult to understand or interpret. This can be understood by a simple example: After finding the company fundamentally sound, a retail investor buys the shares, but after single negative news, he gets panicked, and squares off, incurring a loss, even after analysing the company so well. 
  • Recency Bias – Recency biased investors may ignore the fundamental value and focus too much on recent upward price movements. If you want to learn more about Recency Bias through an example, Google “Ruchi Soya Stocks”.
  • Overconfidence Bias – Overconfident investors are prone to trade excessively as a result of believing that they possess the right kind of skills that others don’t have.  

 

The Institutional Investors

Both Fundamental & Technical Analysis done by the Institutional investors can be highly trusted. As their aim is to be profitable in long term investments, they are very less influenced by the short term market trends, and panic among the retail investors. Institutional Investors look for stocks with low market prices and good fundamentals, as they are the ones who place bulk orders. Also, in IPOs & FPOs they play crucial roles. 

The macroeconomic factors are the biases in the case of institutional investors, as they target to invest in diversified portfolios, their decisions are influenced by the economic stability, stock market, and corporate world’s condition. Institutional Investors’ perception towards the market also influences the decisions of retail investors. 

 

Judging the Company Fundamentally

Apart from the psychological factors, one of the most important factors that helps both types of investors, is the Fundamentals of the company. Profit Margins, Return on Equity, Price to Earning Ratio, Price to Book Value are one of the most famous ratios that investors use to analyse a company’s performance. 

Another parameter that investors consider before finalising the investment decisions, is comparison of estimated market price of the share with the actual (current) market price of the share. In order to find the estimated market price, we need the Intrinsic Value.

 

The Intrinsic Value

The intrinsic value is the estimated value of the business calculated by predicting the future cash flows of the company. It is also called the True Value of Asset. In the Discounted Cash Flow method, the estimated future cash flows and time value of money are used to get the intrinsic value. Different traders have different assumptions and understanding about both the company and the market, and can derive slightly different intrinsic values in their respective models.

Warren Buffett’s investment secret has been targeting the stocks with intrinsic value more than the market price of the stock. He is known for determining the most accurate and the least biased intrinsic value of companies.

 

Free Cash Flows 

Free Cash Flow is the surplus cash left with the company after bearing their capital expenditure. The Free Cash Flow amount is used to pay off debts, further investments in business (expansion and diversification), or it is declared as dividends to the shareholders. Free Cash Flow only considers the cash generated from operating activities of the business. 

When a company spends more than what they earned or gets negative cash flows, they raise funds through debt or equity to fulfill the cash requirements. So if a company is issuing public offerings or raising debt, to pay off old debts and not to further reinvest in the business, you should analyse the firm carefully. 

If a company is struggling with the negative cash flows over a long period of time, then they need better management. Investors usually target those companies who have the ability to generate enough cash flow surplus, further reinvesting it in the business and grow. 

The reason why it plays an important role in Fundamental Analysis is, the Free Cash Flow is the base of determining the Stock Prices and Intrinsic value. So, if you are new in the investment world, and looking for the right stocks, should consider Free Cash Flow in your top 5 parameters to judge the company.

 


 

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