For someone new to Wall Street, stock prices may seem mysterious. They go up and down; people make and lose money. But why do they move? Who or what decides where those stock prices land every day? While there are many factors that affect a stock's price, there are basic principles that can help give you a sense of why a stock is valued the way it is.
To build foundational knowledge, we'll start off by explaining what the capital markets are and how they work. Then, we'll dive into how stock prices are determined. You'll learn about two essential theories: the Efficient Market Hypothesis (EMH) and Intrinsic Value Theory.
Understanding Capital Markets
A big part of understanding the rationale behind stock prices is understanding the capital markets in general. The capital markets, often simply referred to as "Wall Street," serve three main purposes.
The Primary Market
First, capital markets establish the primary market by connecting savers of capital with those who want to raise capital. In other words, a business owner who wants to start or grow a business can use the capital markets to connect with investors who have money to spare.
There are two primary ways a business raises capital: bonds and stocks.
A company that issues bonds is essentially establishing a loan deal with an investor, and the company agrees to pay back the loan plus interest over a set timeline. A company that issues stock is selling partial ownership in the company. Instead of getting repaid, like a loan, the investor will instead sell that partial ownership at a later date—hopefully after the company has grown and increased its value. As the company's value rises, the stock's price does, too, though there are other factors to consider.
The Secondary Market
Secondly, capital markets facilitate a secondary market for existing owners of stocks and bonds to find others who are willing to buy their securities. The secondary market is complementary to the primary market through the liquidity it provides. Investors are more comfortable investing if they have confidence that they will be able to find someone to buy the securities they want to sell.
Lastly, capital markets provide a way for ordinary people to outsource their investment decisions. When investment decisions are handled by someone else, people can focus on their primary career or activity.
Capital markets create the opportunity for institutions and individuals to invest on someone's behalf—for a fee. This investing is sometimes done through a broker-dealer. Increasingly, this is done through a firm that is a registered investment advisor (RIA). An RIA is bound by a fiduciary duty to put the interests of clients above the interests of the firm.
How Stock Prices Are Determined
After shares of a company's stock are issued in the primary market, they will be sold—and continue to be bought and sold—in the secondary market. Stock price fluctuations happen in the secondary market as stock market participants make decisions to buy or sell.
The decision to buy, sell, or hold is based on whether an investor or investment professional believes that the stock is undervalued, overvalued, or correctly valued. If the price of a stock is $100 but is believed to be worth $90, then it is overvalued. If it is believed to be worth $110, then it is undervalued.
So why would the stock price be $100 when it's potentially worth $90, or even $110 per share? It comes down to the supply and demand in relation to the volume of shares being bought and sold. It's the investors, or partial owners, buying and selling among themselves that determine the current market value of a trade.
The Ask and the Bid
The potential buyers announce a price they would be willing to pay, known as the "bid." The potential sellers announce a price they would be willing to sell, known as the "ask." A market maker in the middle works to create liquidity by facilitating trades between the two parties.
Put simply, the ask and the bid determine stock price.
When a buyer and seller come together, a trade is executed, and the price at which the trade occurred becomes the quoted market value. That's the number you see across television ticker tapes, internet financial portals, and brokerage account pages.
Theories Behind Stock Prices
While the ask and bid essentially create a stock's price, that doesn't touch on bigger issues like why a seller was willing to sell at a given price, or why the buyer was willing to pay a certain amount.
Efficient Market Hypothesis
Some people don't think there's a point in asking those deeper questions, and that kind of thinking is known as Efficient Market Hypothesis. The theory is that a stock price reflects a company's true value at any given time—regardless of what analysis of the company's fundamentals or broader market trends might suggest.
EMH believers are proponents of passive investing, a strategy that takes a broad and neutral approach, as opposed to focused analysis and timing. The thinking is that no amount of research could predict the randomness of the market, so it's best to buy as broad a range of stocks as possible and hold onto those stocks for as long as you can.
EMH is not a universally accepted theory, and it's actually highly controversial in some investing circles.
Intrinsic Value Theory
On the other side of the theoretical spectrum, you'll find Intrinsic Value Theory. This theory states that companies trade for more or less than what they are worth all the time.
The company's real value, something Benjamin Graham called "intrinsic value," is the net present value of the owner's earnings. It is the cash that can be extracted from the enterprise from now until the end of time, based on the actual productive capacity of the business itself. In other words, how much money is the company making, and how long can it continue making that amount?
Investors that follow this theory are "value investors." They include famous investors like Warren Buffett (whose mentor was Benjamin Graham). His widely attributed quips draw from this outlook, including his belief that "if a business does well, the stock eventually follows," and "it's far better to buy a wonderful company at a fair price than it is to buy a fair company at a wonderful price." When something causes a company's stock price to fall, a value investor will scrutinize it and decide whether it presents an opportunity to buy.
The Bottom Line
In order to understand how stock prices are determined, it's important to first know how the capital markets work. Within the capital markets, buyers and sellers collectively help determine the stock price. There are many factors and theories on why stock prices fluctuate, but two theories are the most cited. The Efficient Market Hypothesis says that a stock price reflects a company's true value at any given time. The Intrinsic Value Theory states that companies may trade for more or less than they are worth.