March 6, 2013
There is no perfect equation that establishes the price of a stock, unfortunately. In the marketplace of buyers and sellers this figure is based on supply and demand; an increase in demand for a stock puts upward pressure on its price and a decrease in demand creates an over-supply and pushes the price of a stock down. Beyond this, there are 3 basic areas that come into play: Fundamental factors, technical factors and market sentiment.
Fundamental Factors -
At its most basic, stock prices are determined primarily by the company’s earnings per share (EPS) and what is called a “valuation multiple” such as price to earnings (P/E). A stock owner has a claim on the company’s earnings, and a stock buyer purchases a proportional share of those future earnings, hence the valuation multiple: it’s the price one is willing to pay for the future stream of earnings. Future earnings reflect both the current level of earnings as well as the expected growth in earnings. These expected future earnings are then “discounted” by factors that include the perceived risk of the stock (a risk premium), a time horizon, and inflation. [Note that EPS is not the only valuation multiple; there are other measures a buyer might depend upon in establishing the price of a stock such as cash flow per share or dividends per share.]
Technical Factors -
Technical factors also influence the price of a stock and may have little connection to the value of a particular company. Some of these include the strength of the market in general; the performance of a stock within the same sector (a negative outlook on one oil stock may drag down the price of another oil stock); competition for investors’ dollars (which could be allocated to other asset classes such as foreign stocks, bonds or real estate); current inflation, which has a strong inverse correlation with stock valuations; and demographic trends (wage earners are more likely to invest whereas retirees may be selling to replace lost income – another supply and demand issue).
Market Sentiment -
Finally, the growing field of behavioral finance explores the psychology of investing. It seeks to explain why investors both individually and collectively make decisions that are biased, subjective, emotional and often fear-driven and have no connection with fundamental and technical factors, yet have a powerful influence over stock prices.
Additionally, there is growing controversy around the use of sophisticated high frequency trading programs that puts the average investor at a disadvantage. Such “flash trading” occurs as thousands of buy and sell orders are automatically implemented by computers analyzing instantaneous changes in prices. The concern is that these orders get placed ahead of all others, driving prices up for the rest of us.
