Rahul, a fresh engineering graduate, wants to invest in the stock markets but has no idea of share trading. He consults his senior Abhishek, who is a successful financial advisor.
“Abhishek, can we start with the basics?”
“Ask to your heart’s satisfaction, Rahul, it is part of my job to teach people how to invest in the stock markets,” Abhishek said. “Also, it is not advisable to invest in the stock markets without proper knowledge.”
“Share prices often confuse me! Why are some stocks priced in hundreds while some in thousands?” Rahul asked curiously.
“Well! The stock prices that we see changing on a daily basis do not count for much.”
“Don’t get me wrong, the stock price is important, but without the context, it does not have any meaning,” Abhishek added.
Rahul had a confused look on his face.
“Let us explain with an example. Consider the stock to be a person. Now if I introduce you to a new person and just tell you his name, will you be able to understand who he is or why I introduced you to him? No. But if I give you the additional information that he is a successful investor and is organising a workshop, you will figure out why I introduced him.”
“Similarly, the price is the most identifiable aspect of stock, but without additional information, it may not be of much help.”
“The price keeps changing and many people confuse the stock price with the value of the stock. Nothing can be farther from reality,” Abhishek continued.
“The stock price reflects the current value of a stock, but doesn’t give a clear picture of the intrinsic value of the stock.”
“So, the stock price does not reflect the actual worth of the company and difference in prices mean nothing when comparing companies,” Rahul asked.
“The difference in stock prices means nothing when comparing the intrinsic value of a company. A company’s shares may be priced at Rs 7000, but the company may be a lot less valuable than a company with a share price of Rs 100,” Abhishek said.
“For the sake of understanding, consider two companies ABC and XYZ. Each share of ABC costs Rs 10,000, and there are 1 lakh shares outstanding in the market. The market capitalization of the company is Rs 100 crores. The share price of XYZ, on the other hand, is Rs 3000, but there are 1 crore shares outstanding in the market. A simple calculation will tell you that the market capitalization of XYZ is Rs 3000 crores, which is much higher than ABC’s.”
“Please note, market capitalization is not a metric to measure the intrinsic value of a company, a lot of other fundamental factors have to be considered. However, it is a useful tool to understand the futility of stock prices.”
“Abhishek, can you also explain what leads to different share prices of different companies?”
“Various factors affect the stock price of a company while share trading. The immediate reason for the difference in the shares prices of different companies is the supply and demand of the share in the market.”
“Suppose, two companies get listed at the same price. If the demand for the first company’s shares is higher than that of the second company and both the companies have an equal number of shares in the market, the share price of the first company will automatically rise higher than the second company’s,” Abhishek explained.
“A few major stocks on the Indian bourses trade at a higher price just due to low free float, which is the number of shares of a company that can be publicly traded.”
“Oh, that is an interesting insight, Abhishek,” Rahul exclaimed.
“The demand-supply scenario is not the only factor that determines the difference in stock prices. Many companies opt for stock splits to make their shares affordable for retail investors.”
“All the learnings about how to invest in the stock market would be a waste if the share price would be out of reach of a small investor. Isn’t it Rahul?”
“Can you explain further?” Rahul asked.
“Consider MRF. Currently, each share of MRF costs Rs 58,500. Now if you want to start share trading with Rs 50,000, would you be able to invest in MRF?” Abhishek questioned.
“Obviously No!” Rahul answered.
“If MRF decides to split the stock in the ratio of 5-for-1, each share will split into five shares, the price of each share will fall and the liquidity will increase.”
“A lower price will give smaller investors an opportunity to invest in MRF,” Abhishek elaborated.
“Stock splits and demand-supply are not the only factors that determine share price. A variety of other factors such as profits, revenue growth and other developments too affect the stock price, which is why some stocks look expensive while others look cheap.”
“I hope you got your answer?” Abhishek enquired.
“Thank you, Abhishek, for the detailed explanation.”
Stock prices rarely move in straight lines
Traders may feel that stock prices will dart in the anticipated direction in a straight line. However, statistically, this is rarely ever true. A large volume of securities being traded the world over, when assessed with time variables, will reveal that taking a position before a move is unlikely. It is better for traders to trade in averages and based on the direction of price movements and market momentum. Fixating on a particular stock is not a sustainable strategy.
The focus should be on the momentum
Keeping up with the momentum in which the whole market moves is regarded as the golden rule of trading in stocks. It is more important than the direction in which specific stocks are going. The overall momentum may be positive, but it may be pushing against the stocks of select sectors. For example, if interest rates are lowered, the banking and auto sectors will benefit and be in favourable momentum.
Now that you know why and how stock prices change, check out our other articles on risk management and other trading tips