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How Are Stock Prices Determined?

Stock prices move up and down during the trading day on Wall Street. At the most basic level, a stock’s price is a function of the supply of shares available and the demand among investors for the shares.

How are Stock Prices Determined?

For stocks traded on public stock exchanges, supply and demand for the company’s shares are a main component in determining the stock’s price at any point in the trading day.

Demand is based on the number of traders and investors looking to buy shares. If the demand for a company’s shares is high this will tend to drive up the price. Just like a consumer product or a commodity, the greater the demand, the higher the price people are willing to pay.

On the flip side, when there are high number of sellers, the price of the stock will be driven down.

As far as the supply side, when companies issue shares, this represents the number of the company’s shares that are available to buy and sell. When companies buy back shares of their own stock, this reduces the total number of shares available for trading. Companies do this in the hope that reducing the number of shares available will help boost their share price.

Primary Markets

When a company initially decides to issue stock that will be publicly available, they work with investment bankers who underwrite the initial issuance of the stock, known as an IPO or initial public offering. They establish an initial price for the stock offering and work to line up investors to buy the shares.

Secondary Markets

Once the initial offering of the stock is complete, investors will be able to buy and sell these shares on the secondary market, meaning the various stock exchanges where the stock might be listed. The ability to trade shares provides shareholders with the liquidity they need should they desire to sell their shares. This is where the concept of the supply of and demand for the shares comes into play to influence the price.

The bid and ask price of the shares will factor in determining the ultimate price at which the shares are traded. The bid price is the maximum price the buyer will pay for the shares, the ask price is lowest price a seller will accept for the security.

For large, widely-traded stocks such as many blue chips, the bid and ask price spread will be pretty narrow. For more thinly traded stocks, this spread can be wider. There are intermediaries called market makers on the exchanges and they play a role in most trades. When the demand for a stock is low, they can play a key role in moving the transaction forward and matching a buyer with a seller.

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Private Stocks

Many corporations issue stock that is privately held and not traded on public stock exchanges. These shares do change hands, though the transactions are facilitated directly between the seller and buyer of the shares. The price at which these shares change hands will be directly determined by the parties to the transaction. Essentially the price is what a willing buyer is willing to pay for the shares. Unlike with publicly-traded shares, there is no ready secondary market for the shares making them less liquid. This can make owning private shares a bit riskier for investors.

Stock Valuation

Besides supply and demand, the valuation of stocks can be influenced by a number of other factors. These can include:

Analysts look at a company’s earning prospects as a primary factor in assigning a valuation to a company. While this doesn’t directly influence the price on a daily basis, many investors pay attention to the opinions of key analysts in making their investment decisions.

Activity by Institutional Investors 

The activity of large institutional investors can influence the price of the stock in terms of large trades they might execute. This might include large endowments or pension plans, mutual funds, hedge funds and others.

Market Conditions

When there is some sort of market event, good or bad, this can impact the price of a stock if only on a temporary basis. For example, during the financial crisis of 2008, the S&P 500 dropped by about 37% in 2008. There were very few winners in the stock market that year.

There are a number of stock valuation models.

The Gordon Growth Model is a dividend discount model using an assumption that a company that pays a dividend will continue to do so and places a value on the stock based on this assumption. The model takes the projected value of the next year’s dividend and divides it by the company’s cost of equity capital less the assumed growth rate in the company’s dividend payout. The sum of all of this is the target price of the stock in terms of the model. This price may or may not be reflected in the current price of the shares at any given time.

The model assumes that the company will both continue to pay dividends and that the payout will likely increase. The price that the model yields is a fair value for the stock based on these assumptions. If the price from the model is higher than the stock’s current market price, then it is considered to be undervalued and potentially a good buy for investors. If the fair value price from the model is lower than the stock’s current market price, then based on the model the shares would be considered overvalued.

For example, as of this writing Morningstar has a fair value for Apple AAPL shares of $220 a share. This is far below the stock’s current market price of just under $310 per share. For those who agree with their methodology they might consider selling their shares to avoid a drop in price over time.

There are any number of pricing models and services that provide stock price estimates. These estimates may vary based on the methodology used. It is important that investors using any stock valuation first understand the methodology and assumptions that underlie the model’s pricing estimates.