How Stock Prices Are Determined
Why Stocks Become Overvalued and Undervalued
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?
Pinning down the exact reasons why a single stock is selling for a certain price is nearly impossible. There are too many factors, some of which simply come down to the personal sentiments of individual investors deciding to buy and sell. However, it isn't too hard to understand the basic principals behind stock prices. While there will always be a level of uncertainty when it comes to stock prices, you can learn what to look for to get a sense of why a stock is valued the way it is.
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," have three main purposes.
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 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 stocks 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, as well).
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 makes the primary market more successful because it gives investors more confidence that they will be able to find someone to buy the stocks and bonds they want to sell, which creates a source of liquidity, or easy access to cash.
Lastly, capital markets provide a way for ordinary people to outsource their investment decisions so they can instead 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 is sometimes done through a broker-dealer. Increasingly, this is done through a firm that is a registered investment advisor which is bound by a fiduciary duty to put the interests of clients above the interests of the firm, including registered investment advisors that are primarily asset management companies. Whoever you hire to manage your money, the point is that you can pay someone else to handle your portfolio so you can spend more time generating income, not reading 10-K filings or mutual fund prospectuses.
The Ask and the Bid
The stock price fluctuations—when stocks become overvalued or undervalued—arise in the secondary market. Once a company has raised capital from investors, it is those investors, or partial owners, buying and selling among themselves that determine the current market value of a trade.
The potential buyers announce a price at which they would be willing to pay, known as the "bid." The potential sellers announce a price at which 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 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 splashed across television ticker tapes, internet financial portals, and brokerage account pages.
Efficient Market Hypothesis
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 for a stock.
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 (EMH). 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, which is 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 of a range of stocks as possible and hold onto those stocks for as long as you can.
Intrinsic Value Theory
EMH is not a universally accepted theory, and it's actually highly controversial in some investing circles. On the other side of the theoretic spectrum, you'll find Intrinsic Value Theory. This theory states that companies trade for more or less than 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 earnings—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?
While intrinsic value is based in part on the analysis of hard data, there's also a subjective element to it. For example, investors may take qualitative factors like leadership style into account when determining a company's value.
The theory also takes into account something known as the "risk-free rate." That's the rate at which your money could be growing in relatively risk-free securities. In the U.S., investors determine this by watching the rate on long-term U.S. Treasury bonds. If you believe a stock is selling for less than its intrinsic value, but the difference isn't much more than the rate on a Treasury bond, or there are significant risks involved, it might be better to avoid taking market risks and invest in the bond instead (or find a company that's selling at even more of a discount compared to its intrinsic value).
Investors that follow this theory are "value investors," and they include famous investors like Warren Buffett (whose mentor was Benjamin Graham). His widely repeated 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 the company and decide whether it presents an opportunity to buy.