Equity as an asset class #5 – The basic logic of pricing

One of the things that had puzzled me greatly when I first started investing in equity was how drastic the price movements of a stock were at times. I remember a particular stock go from 30 Rs a share to about 200 Rs a share in a span of 3 months and another go from 300 Rs to about 65 Rs. In both cases nothing much had changed in the respective company performances or their prospects. I do not claim to be an expert on stock pricing – however, with my long experience in the equity markets I do have a better understanding of this now than before. Let me try and share it in this post.

The most important factor responsible for the stock price is the supply and demand for that particular stock. As we know from Economics when supply is exceeding demand prices tend to drop and when demand outstrips supply prices tend to rise. For a particular stock, the shareholders will either want to buy more of it or sell their holdings at some points in time. If there are more stocks to be sold than there is demand prices will drop. On the other hand, if there are a lot of buyers in the market and limited shares available for sale the price will rise.

Let me try and illustrate this by an example. I have 1000 shares of a company X which is a market leader in its sector. In one quarter the results are likely to be declared poor. As it so happens, I need money at this particular juncture for one of my goals. I want to sell it at 1000 Rs per share which is the current market value. However, in anticipation of poor results the demand for X is muted, so at 1000 Rs I find no buyers. Now like me there are several shareholders of X who are trying to sell. I and others will be forced to offer a lower price if we are very keen to dispose of the shares. At some point, buyers will start getting interested. Maybe at 1000 Rs there was no interest but at 900 Rs there may be some buyers. Depending on how strong are the selling needs of the shareholders and the strength of demand, the price can drop alarmingly at times.

Remember when the Satyam scam broke in early 2010? The stock went from 100 Rs to about 6 Rs in a matter of hours. The simple reason was that many people were desperate to sell the stock and no one wanted to buy it. Now this was a classic case of seller desperation as most shareholders believed that the shares will have no value whatsoever soon. In this scenario, they were prepared to sell almost at any price, irrespective of what price they may have bought it at. As the price kept dropping some buyers got interested – their logic may well have been that the company will reorganize in some manner after the existing promoters are out, so it will be a good idea to get it really cheap. In hindsight they have been proved to be correct !!

Almost the exact opposite happens when there is high demand for a stock. In the above case of Satyam, when the government got its act together and Tech Mahindra took over the company, the stock price recovered. This was because people started believing the company had a future and therefore were interested in investing in the same. As demand was more than supply, the stock price kept increasing. The recovery in the stock price was of course much more gradual when compared to the fall, as in this case the level of buyer desperation was not that high.

One important thing to understand at this point is that there is really no base price of floor price for a stock. Yes, every share has a face value but that is not really a support price, further it is normally a low value anyway. So depending on the demand and supply dynamics, the prices can really be almost anything in practice. You will thus find a Maruti sold at 125 Rs in IPO, quoting 4000 Rs now. You will also find Kingfisher Airlines at 1.5 Rs, from a high of 300 Rs and more ( For Deccan aviation, IPO was at 146 Rs).

So, we are now clear about one aspect. In order to understand the price movements of stocks we will have to understand what drives demand and supply in the markets and for a particular stock. I will address this in the next post.