“I never understood how stock prices are calculated“, told a friend of mine some days ago. Well, we’ll try to help a bit, giving a little in-depth to some ideas we briefly talked about some time ago. We’ll try not to get too technical, and although here we’ll talk mainly about share prices, many concepts are also applicable to other financial instruments.
In theory, price determination is simple: the share price (which represent of a share of ownership of a company) is determined through an auction involving those in possession of shares, that wants to sell them, and whoever wants to buy (Ok, there are a few peculiarities, but the basic concept is this).
So the price depends, fundamentally, from how much are willing to pay those who want to buy shares, and from how much want to be payed those who own them.
- How are connected today’s share price, and yesterday’s one? Simply said, technically they are not connected, if not from the fact that if today pepole are willing to pay 100 for something, tomorrow – if nothing happens in the meantime – it’s reasonable that people will be willing to pay more or less the same price. But usually something happens in the meantime, therefore the fluctuation you see in stock prices.
- What if nobody wants to buy the shares I own when I want to sell them? In financial terms, this is a liquidity problem, and it may happen (not – usually – with regular shares, but it may be an actual problem in case of peculiar financial instruments), and it may happen when there are few buyers. The consequence, usually, is that you will be able to sell your shares, but maybe at a lower price, since there will be less competition in the auction. In the end, all can be led back to a simple idea: if you are more in need to sell than your counterpart is in need to buy, you will get a lower price than in the opposite situation. Thus, as a general rule, you should check the liquidity of what you’re buying.
All this can be combined with the concept of “right value” of a share, that we discussed previously. In fact, the ideal price is the net present value of all future cash flows related to the share’s possession (i.e. mainly dividends). That’s because if I keep the share for an indefinite time, that’s the fair price at which it’s reasonable to buy.
Effectively, this definition is not very useful (since it’s impossible to estimate precisely enough future cash flow, and even the actualization rate may be difficult to define), but in my opinion it’s something that one should keep in mind, to understand why stock market is so sensitive to disparate events: basic commodities prices, unemployment rates, and so on. In fact, all these elemets affect, even if indirectly, on profits that the company can earn in the future, and therefore on cash flows for the shareholders, thus on their net present value, that means on the share value.