Stock prices are first decided upon its initial public offering (IPO), the very first time when the shares are listed in the market. This is the process whereby a privately owned company takes the first step to being transformed into a public company whose shares will be traded on a stock exchange. Investment firms use various modelling methods such as comparing to companies within similar industries and past financial records to determine what the share price would be.
Upon the completion of IPO, share price of a stock will move due to market forces as explained by the law of supply and demand. The fundamentals behind this are easy as we know it. While this level of understanding is easy to grasp, there are other factors that cause the changes in share price.
In an efficient and open market, a company’s share price is determined by its earnings base and a valuation multiple. As an investor, you would want to invest in a company that is capable of generating returns as you own a certain amount of shares and have a proportionate claim towards the earnings. This is the reason for a valuation multiple to exist because the price today is what you are willing to pay for the future stream of earnings.
These expected future earnings are then built into the prices today. In other words, the price you see today represents the discounted present value of anticipated future earnings. While the most commonly known earnings power is using the accounting measure earnings per share (EPS), some investors prefer to adopt the cash flow based method or dividend discount model. Factors related to the company, industry, and economic news can all have an impact on the price movements.
While the above methods will not go wrong theoretically, market sentiment is typically what hypes a stock. Market sentiment is often subjective and may be biased as it comes from investors individually or collectively. While one may feel confident about a company’s potential earnings, the market may choose to dwell on a single piece of bad news and thus keeping the stock price low, or vice versa. As a relatively new field of behavioural finance, this area of study focuses on psychological influences that affect market outcomes.
With over thousands of companies to choose from an index, it is pretty much impossible to research and study each individually. Remember back in school how only the popular kids get talked about? This pretty much works the same within the investing community. Popular and well-known companies are usually favoured for a few reasons. These companies usually have strong and powerful leaders that are admired due to their personality or charisma, and generally produce a brand that is trusted by the public.
Each investor chooses to believe and rely on different factors, like how long term investors prefer long term fundamentals, whereas short term investors or traders might incorporate technical factors to determine if the share price is bullish or bearish. Stock price movements can sometimes be difficult to comprehend, as we slowly begin to realise that traditional finance theories do not explain everything after all.