For many investors stock investment journey begins with understanding how the share price is decided. Stock prices are not fixed. The demand-supply dynamics of the market are responsible for the changes in stock prices. For example, if there is more demand than supply, the price will increase. Similarly, it will fall when supply exceeds demand.
In the stock market, the price is determined by a price discovery mechanism. It happens when the buyers and sellers agree on a price level. Stock prices depend on the bid and ask price of the stock. A "bid" is an offer to buy a certain number of shares for a specific price. An "ask" is an offer to sell a certain number of shares at a particular price.
Exchanges calculate a stock's price in real time by finding the price at which the maximum number of shares are transacted at the moment. The price changes if there is a change in the buy or sell offer for the shares. It is the market price of the stock and it can be different from the intrinsic price. Let us start with looking first at how intrinsic value fo a share is determined.
Determining the intrinsic value of the stock
To determine whether a stock is overpriced or underpriced, you must determine its fair or intrinsic price. Intrinsic value (or IV) plays a critical role in decision-making and assists investors in calculating returns.
Various critical internal and external factors influence the stock price in the market. New developments in the company, demand and supply components, macroeconomic conditions, etc. affect the stock price. It implies that the stocks trading on the bourses are not always fairly priced.
Buying stocks at their fair price will give you better returns on investments. However, if you are not aware of the fair price of the stock, you may end up paying a higher price. IV helps you gauge the difference between the stock's correct price and its market-influenced value.
Methods to determine the intrinsic value
The three most popular ways to determine the intrinsic value of a stock are stated below.
- Dividend discount model
The method uses the total present value of all the company's future dividends. If the calculated stock prices are higher than the present value of the future dividends, the stock is undervalued. Similarly, the stock is overpriced if the opposite scenario plays out.
Here is the process for calculating IV using the DDF share price formula.
IV=EDPS(r-g) + present value of the expected selling price of the stock
EDPS= Expected dividend per share
R= the cost of equity capital
G= the dividend growth rate
- Discounted cash flow
The DCF method calculates intrinsic value by taking into account the future cash flow generated by the company.
Discounted cash flow =CF1(1+r)1 +CF2(1+r)2+.....+CFn(1+r)n+terminal value of the business
r= the rate of discount
- Relative Valuation Method
The relative valuation method compares the stock price with the company’s fundamentals like revenue, net income, profit, PR ratio, and the book value of the equity share with its peers. When the PE ratio of the stock is lower than the industry average PE, the stock is available at a cheaper rate.
How the share price is decided
With an understanding of a stock’s intrinsic value, let’s now consider the other factors responsible for determining its price in the market.
When company stocks are available for trading, sellers quote a price at which they will sell the stocks. Conversely, the buyers also quote their price. The trade happens only when both parties agree. When a buyer offers a higher price, the seller agrees to it, and the share price rises. But what makes the buyer’s offer?
The attractiveness of the industry
Buyers pay a higher price if they believe the stock will earn a higher return. So, companies on the growth path attract more buyers for their shares. The basis of the decision depends on the factors stated below -
- If new competition is entering the sector
- The future scope of growth
- The company enjoys authority over determining the value of its products
Investors will invest in companies that are performing well. If the company is on a growth path, generating good returns on investment, has a sustainable business model, good management, and maintains good liquidity, the share price will be its share price.
The role of the management can sway investors' sentiments. The company’s management profile and leadership affect the stock price. An announcement or commentary by the management will have an immediate effect on the stock price.
Major changes in the business, management and policy
The stock price can increase if there are any management changes, especially if investors believe the changes to be positive.
Similarly, changes in government policies and regulations also affect stock prices because changes in the law will impact the company’s business model. For example, if the government announces an increase in foreign investment in the sector, the company's share price might rise.
Liquidity indicates the quantity of stock that is in demand in the market. If the stock is highly liquid, it is easier for the sellers to sell. It also affects the stock price, as buyers are more willing to buy these shares when there are many buyers and sellers available.
Companies with a competitive advantage over peers will enjoy a higher share price than others. When a company is in a near monopoly industry, it is protected from competition - therefore, it can exercise better control over product prices and customers. Because of their special position in the segment, these company stocks generate substantial profits, which in turn increase the stock price. Therefore, companies with monopolies or strong market shares can enjoy higher share prices.
Factors that affect multiple stocks
The following are the factors that affect not just one stock but stocks across a sector or even across the economy as a whole , at once-
- Interest rates
- Changes in economic policies
- Market sentiment
- Industry trades
- Global fluctuations
- Natural disasters
What is the PE ratio?
The PE ratio is determined by dividing the price by the most recent earnings per share (EPS). A lower PE ratio of below 20 is considered good for investing. A PE ratio above 30 is considered high, because historically, NIFTY has traded in the range of 10 to 30.
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