Equity as an asset class #6 – A more detailed look at pricing

In the last post we saw how the price movements of stocks are fundamentally determined by demand and supply. In this post we will try to understand these a little more and take a more in-depth look at stock pricing. Based on my philosophy of nor reinventing the wheel, I have taken information from the internet, especially Investopedia, from where there are some quotes.

The basic determinant of demand is what the investors feel about the worth of a particular company. Obviously, if a company is doing well in terms of revenues and profits and also has the potential to grow, it will be deemed to be worth something. The true value of a company is not reflected in its share price but rather in its Market Capitalization which is defined below:-

Market Capitalization = Shares outstanding X Current market price

This figure is also the basis of categorizing companies as large cap, mid cap, small cap etc. Chances are that the share price movements of large cap companies will be somewhat less volatile and so on. This is often the case though there are always exceptions to this situation in a turbulent market or sector.

There are two most important contributors to the market price of a share. The first is Earnings of the company. As we know all listed companies have to declare their quarterly results every quarter, giving financial details of their performance and also explaining how the outlook of the business is. If these results are good the demand for the shares of the company will increase and this will normally push up the share price and consequently raise the market cap. The reverse will be true if the earnings are poor and the current shareholders want to sell off the shares of the company. This increases supply of the stock in the markets, lowers the price and in effect reduces the market cap of the company.

How is it then, some companies making huge losses have great market caps. This is where the second determinant, namely News flow based perception comes in. The earnings of a company may be poor but if the news flow is positive and that leads investors to believe that the company has a great future, then enough investors would want to buy the shares. This will push up the share price greatly as there is limited supply, in the absence of many sellers in the market. It is therefore not unusual to see companies that have high share values though their revenues and profits are poor. Over time however, these expectations need to get converted into performance, otherwise the prices cannot be sustained.

There are several theories about predicting the future price of a stock by looking at the prior performances of the same. This may work at times but it is really not definitive by any means. In the next post, I will look at something more practical, on how you can arrive at a logical price to buy a stock.

I would like to sum up this post by quoting from Investopedia:-

1. At the most fundamental level, supply and demand in the market determines stock price.
2. Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.
3. Theoretically, earnings are what affect investors’ valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors’ sentiments, attitudes and expectations that ultimately affect stock prices.
4. There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain everything.

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