How are stock prices determined?

When we look at the stock market, the first question that comes to our mind is:

• "How exactly are these stock prices changing?" 
• "How is the price of a particular stock determined?"
• "Who is behind all this?"

To determine the price of a particular stock various analyses and steps are involved, but the base concept is pretty simple. We are not going deep into analysis stuff. We are going to discuss the basic meaning and essence of determining stock prices.

First of all the 'headline stock price' we see quoted on the stock market is the price at which the latest transaction occurred.

The above picture shows the current stock price of Infosys. It means the last time someone sold or bought this stock, it was at the price of Rs.956.90. This is the most recent price at which both the buyer and seller agreed to transact. This price keeps going up and down and is displayed on the screen.

To be absolutely clear the headline price is not the price at which one can buy or sell at that moment. It is the price at which the latest transaction occurred. To be able to buy the stock one will have to quote either above or below this latest transaction price. Probably, Rs.956.91, Rs.956.92 or Rs.956.89, Rs.956.88 depending upon the market movement.

This highlights the question, "How does one know that Rs.956.90 the right price to buy a stock? Why not buy at Rs.1000 or when it declines to Rs.800?".

Generally, this discussion is put to rest with the idea that price of a stock like any other commodity is decided by the demand and supply. It is true but vague. What is guiding this supply and demand? Let's see.

LET'S START WITH BASICS

When you buy a company's stock, you in essence by a part of that company. You become one of the owners of that business. There are millions of shareholders in a company each owning a small part of that company. 

For example: Total Infosys shares in the market are 4,259,154,628. If you buy 10 shares out of these, you own a mere .000000235% of that company. The numbers are incredible isn't it? Nonetheless, you are an owner.

HOW DO OWNERS EARN MONEY

• Businesses generate money when they succeed in their particular sector and generate money from the goods or services they provide. 

• Then payment has to be made for the various expenses they incur, like employee salaries, payment to the vendors or the companies to which some service has been outsourced, etc.

• The cash left after all this is the cash that can be given back to the business owners. This is also know as Free Cash Flow. 

Businesses earn this free cash flow every year. This means you are entitled to a part of this cash flow, according to your % shareholding in the company till the time you are holding the shares.

Suppose, Infosys generates Rs.6,00,000 crore over its lifetime.

Rs.6,00,000 crore/4,259,154,628 shares 

= Rs.1408.73 per share

This is known as Future Value which investors are expecting to get over the company's lifetime.

This Rs.1408.73 is the value per share that owners can expect to receive in the future as company generates free cash flow.

WHAT DIFFERENCE WOULD FUTURE VALUE OF A STOCK MAKE ANYWAY?

When you know what amount can you get back out of the stock in the future, rationally you would not want to pay anything more than this future amount. Not even equal to this future amount, as it would then be a case of no profit and no loss. 

A price less than Rs.1408.73 will make sense.

Why would a price less than Rs.1408.73 make sense?

There is a logic to that as well. We are talking about getting Rs.1408.73 per share in the lifetime of the company, which is unforseen. We are betting for the future. Thus, we will definitely like to make a profit as that future time arrives.

To find what price to buy the stock at to make a decent profit, let's work backwards.

Assuming,

Infosys would pay us the Future Value of Rs.1408.73 per share next year itself. Stay calm, its not gonna happen in reality ;)

The return that we are expecting on this stock in the next one year is 10%. Let's say......

Then the maximum price we will be willing to pay today to get this 10% return in the future is

                            

Rs.1408.73/(1+.1)^1 = Rs.1280.66

And what's the current stock price? It's Rs.956.90.

WHAT IS INTRINSIC VALUE?

This Rs.1280.66 is known as the 'Intrinsic Value'. Investors always recommend to buy stocks below their intrinsic value, which is also known as 'True Value'.

Intrinsic value refers to some fundamental value of an object, asset or financial contract. It can also be referred to as the value reached after converting all future cash flows of a company to the present value.

I'm sure now there is little more clarity on 'what is intrinsic value?'.

Now, let's move further ahead to understand whether a particular stock price is appropriate for buying the stock having intrinsic value as the reference point.

Investors have different ways of analysing stocks and reaching their intrinsic value. 

Sentiment also has a role to play here. Some investors and analysts might be more optimistic about a company and its future and some not so optimistic and some completely negative.

Investors analyse this intrinsic value in order to estimate the price they would be willing to pay to buy the stock.

Generally it has been observed Retail Investors do not keep the intrinsic value of the stock in consideration, which is a mistake! On the other hand, Institutional Investors mostly have a good idea of this pearl in the ocean of stock market - intrinsic value.

"Pearl in the ocean of stock market" - I made this up. Please don't kill me if you didn't like it 😂.

Let's continue.....

Since, institutional investments are quite large in size and their action to buy or sell a stock affects the stock price. 

When investors have got an understanding of the stock and their preferred prices they would wait for the right time and then bid for it. Similarly, the current shareholders will look for price which is suitable to them in relation their estimated intrinsic value and then sell.

HOW DOES INTRINSIC VALUE GUIDE THE DEMAND & SUPPLY FORCES?

As explained in the above figure, if investors believe that the current stock price is way below the intrinsic value, then there will be more demand for the stock and this will push the stock price upwards.  

In the second figure, if investors believe that the current market price of the stock is more than its intrinsic value, then they would want to sell the stock which would lead to decreasing stock price.

EXAMPLE TIME!

• One investor estimates the intrinsic value to be Rs.998 and bids for the stock at Rs.963 
• Another investor estimates the intrinsic value to be Rs.990 and bid for the stock at Rs.960 
• According to seller's estimate the intrinsic value comes out to be Rs.958. 

He has two bids on the table. He accepts the bid at Rs.963.

The this new transaction price would reflect on the stock market. The price will rise from Rs.956.90 to Rs.963.

This is how intrinsic value helps in setting up demand and supply in the market which then leads to change in prices.

In the long run, as company's performance and dynamics change, so does its intrinsic value. The stock price follows this intrinsic value.

To quote Mr. Warren Buffett,

“Market prices of stocks fluctuate at great amplitudes around intrinsic value but, over the long term, intrinsic value is virtually always reflected at some point in the market price."

The example provided in the above explanation is was provided just to simplify explanation. 

• We assumed the earnings of the company. How much will it be in real life? Depends on one's investment analysis.

• The amount that would be received and that it would be received next year is also based on assumption. Realistically the cash flow will be spread over multiple years.

• Assumption was also done in context of the rate of return, '10%'. In actuality it varies. Also risk to return analysis has to be done in order to see if the return is worth the investments.

Ps: There is a bigger picture behind why stock prices change and how is it determined. This is just one aspect of it. There are lot of things to understand and learn.

If you have any after thoughts or would want to know about some stuff, comment below in the comments section.

Alright folks! Stay inquisitive 💡

Written by: Aastik Pasricha