How Stock Prices are First Set?
When a company decides to become public and wants to issue shares to the public, the company must first go through a very complicated process called an initial public offering.
An IPO is when a company pays an investment bank to use very complex formulas and valuation techniques to derive a company’s value and to determine how many shares will be offered to the public and at what price. For example, a company whose value is estimated at $100 million may want to issue 10 million shares at $10 per share or they may want to issue 20 million at $5 a share.
The value of the company isn’t always calculated as how much the company is worth now. Take Uber as an example. Uber has not been profitable for many years, but the potential for profit is what drives the price of their shares.
Uber, as outlined in its IPO prospectus, represents a vision of the future in which labor will be parceled out by algorithms that match supply to demand in real time. Workers will move fluidly between gigs, untethered to traditional jobs. And at the same time, the market for transportation of all kinds will become unmoored from large asset purchases—such as cars—as well as public services.
In short, the stock prices are first set by investment banks to forecast the current value of the company taking account of the potential for income in the future. In the example of Uber, the price is set on the prediction that Uber will transform the transportation industry into a gig based economy versus the traditional government infrastructures such as public transportation.
Here’s a beginner’s guide to stock and bonds if you want to learn more.
What Drives Stock Prices?
Stock prices, like all prices is driven by the law of supply and demand. Demand is the desire of a buyer and their ability to pay for a particular commodity at a specific price. Supply is the quantity of a commodity which is made available by the producers to its consumers at a certain price. When demand increases supply decreases, i.e. inverse relationship.
- The supply of a stock is simply how many shares there are. That’s it. It’s the most simple form of supply there is. At any price per share, there is always the same number of shares.
- The demand of a stock is how many shares the market is willing to own, in total, at any given price for each share. Intuitively, the market demand is precisely equal to the sum total of each individual’s demand.
In the example above, there is only a fixed amount of shares available in the market. As investors holding the shares sells more than the amount of buyers that are willing to buy, the red line (supply curves) begins to move to the right. When there are more sellers than buyers, there is an overflow of supply and thus causing the price to drop.
There is the opposite affect when there are more buyers than sellers. When there isn’t enough supply in the market, the only way to purchase the share is to purchase it at a price that the seller is willing to sell. With a lack of supply, the red supply line moves left and causes the price to increase.
Think of Supreme, the street wear brand. Every month, they release a very limited production run of a few products. Because of the demand of these products, it doesn’t matter what type of products come out, people line up hours ahead of the store opening for the chance of buying anything that comes out. They do this because the products often resells in the secondary market for 5+ times the original price.
The most famous example is the Supreme Brick. Originally priced at $30 USD, now can go up to $199 USD+ on the resell market. There’s nothing special about this brick. It’s just the Supreme logo engraved into the brick. This is the power of supply and demand.
Factors Affecting Stock Prices
The million-dollar question is figuring out if the price of a stock will go up or down. If you do it well, you can end up like Warren Buffet, CEO of Berkshire Hathaway, who has a net worth of over $82 billion as of 2019. Do it poorly and it’s no different than gambling your money away at a Casino.
If predicting the stock market is easy, there will be lots more billionaires in the world. Unfortunately, there are millions of factors that can have an impact on the stock price. It’s the ability to look at which factor at the correct time that can give you the advantage in the stock market.
Economics: The price of a stock might be impacted by factors beyond their control such as the global economy or political climate.
- Interest Rates: interest rate is how much interest is paid by borrowers for the money that they borrow and often set by the central bank. In case of lower interest rates, demand for funds is higher and the subsequent demand for shares rises and vice versa.
- Dividends: When companies make dividend announcements, the share prices of such companies are likely to increase. It is important to note that if the dividend rate announced is lower than the investors’ expectations, share prices decline while if they are up to more than expected, share prices increase.
- Economy: Fluctuations in the economy feature what are commonly referred to as booms and depressions. Under favorable conditions share prices are at their peak and their lowest point is experienced during depressions. Share prices gradually rise during recovery and fall during recessions.
Health of Company: The price of the stock is driven by the likelihood of the company to grow and provide positive returns for its shareholders. There are key indicators to determine the financial condition of a company.
- Liquidity – Quick Ratio: divide current assets by current liabilities. A quick ratio lower than 1.0 is a danger signal, as it indicates current liabilities exceed current assets.
- Solvency – Debt to Equity Ratio: indicator of a company’s long-term sustainability, because it provides a measurement of debt against stockholders’ equity, and is therefore also a measure of investor interest and confidence in a company.
- Operating Efficiency – Operating Margin: This metric indicates not only a company’s basic operational profit margin after deducting the variable costs of producing and marketing the company’s products or services; it thereby provides an indication of how well the company’s management controls costs.
- Profitability – Net Margin: the ratio of profits to total revenues. A larger net margin, especially as compared to industry peers, means a greater margin of financial safety, and also indicates a company is in a better financial position to commit capital to growth and expansion.