How are stock prices determined? Simplified with an example

How are stock prices determined? Simplified with an example

Wed, 03/16/2016 - 21:54
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When I started my study in stock markets, I always got this question "How the initial price of a stock is determined and What affects stock price so that they move up and down?". But I didn't found any simplistic explanation for this question. Eventually, I got clear idea about it and in this post, I will answer this question with an example so that anyone can understand it clearly.

How are share prices determined during IPO?

When a company is about to go public through Initial Public Offering (IPO) they appoint the Merchant banker to do series of things.

One of those things is to determine Price band (lower and upper limit of the share price within which the company will go public) of an IPO.

Merchant banker evaluates company's current and projected performance and health to estimate price band. Merchant banker can do this by comparing the company with the IPO of another similar company, or by calculating the net present value of the firm. The company and merchant banker will meet with investors to help determine the best IPO price band through a series of road shows.

Finally, after the valuation and road shows, they apply to Stock market regulator (Like SEBI in India) with a registration statement. Stock market regulator decides if the IPO price is fair or not. After this company shares offered to public in Primary Market with regulator accepted price band.

How are stock prices determined in share market?

Once trading starts, share prices are largely determined by the forces of supply and demand. I will explain this with an example -

Take an example company ABC. ABC current price is 1000.

Suppose today at 10 am ABC will announce company’s quarterly results.

At 10:00 AM Results comes out company gives excellent results which are more than expected.

At this point how will stock price react to this news? Obliviously the stock price will move up. When positive announcements are made market participants tend to buy the stock at any given price and this cascades into a stock price rally.

Let me illustrate this further :

Shares buying example

Notice, whatever prices the seller wants the buyer is willing to pay for it. This buyer-seller reaction tends to push the share price higher.

So as you can see, the stock price jumped 17 points in a matter of 5 minutes. Though this is a fictional situation, it is a very realistic, and typical behavior of stocks. The stock’s price tends to go up when the news is good or expected to be good.

In this particular case, the stock moves up because results are excellent and more than expected. Sometimes in this scenario when no seller is ready to sell. Price hits upper circuit.

Now I will take the same example but in opposite way.

Suppose ABC posted very bad quarterly results. How will market participants probably react to this news? If one were to initiate a new trade based on this news, it would be a sell on ABC. So it will look something like this.

Shares selling example

Sometimes in this scenario when no buyer is ready to buy. Price hits the lower circuit. stock’s price tends to go down when the news is bad or expected to be bad.

At this stage, you may have a very practical and valid question brewing in your mind. You may be thinking what if there is no news today about ABC? Will the stock price stay flat and not move at all?

Well, the answer is both yes and no, and it really depends on the company in focus.

For example, let’s assume there is absolutely no news concerning two different companies.

  1. Apple Inc. (NASDAQ)
  2. Cosi Inc. (NASDAQ)

As we all know, Apple is one the largest companies in US. Market participants continuously buy and sell shares of this company, regardless of whether there is news or not.

The second company Cosi Inc. is relatively unknown. That is the reason why it may not attract any market participants’s attention as there is no news or event surrounding this company. Under such circumstances, the stock price may not move or even if it does it may be very marginal.

To summarize,

The price moves because of expectation of news and events. The news or events can be directly related to the company, industry or the economy as a whole.

In some cases,when there would be no news but still the price could move due to the demand and supply situation.

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