Jul 14, 2022
How Are Stock Prices Determined?
Stock prices are determined by the relationship between buyers and sellers, and dictated by supply and demand. Buyers “bid” by announcing how much they’ll pay, and sellers “ask” by stating what they’ll accept. When they agree on an amount, it becomes the new stock price. As long as buyers and sellers continue to agree the price is fair, it will stay the same. But it changes every time a buyer and seller land on a price different from the current published price.
In this article, we’ll cover:
- How stock prices are set
- How supply and demand impact the stock market
- Factors that can affect stock prices
How do stock prices work?
When a company makes its initial public offering or IPO, it sells shares to the public at a set opening price, usually determined by an outside firm’s valuation of the company. Sometimes businesses also have a secondary offering to raise additional cash.
Once a company has gone public through an IPO, people can buy and sell its shares on a stock exchange or stock market like the New York Stock Exchange, Nasdaq, and many others. Stocks traded on exchanges don’t have pre-set prices. Unlike a loaf of bread at the supermarket, which is priced in advance, a share of stock is priced through an auction. The price is not set until the buyer’s bid and the seller’s ask meet. The amount they agree on becomes the share price.
Why do stock prices fluctuate?
Because of how stock prices are determined, people continue buying and selling shares for the same price as long as all parties’ valuation of a stock stays the same. But if the buyer or seller believes the stock is undervalued or overvalued, bids and asks will diverge again, and the stock price will change after a new agreement is reached. This push-pull causes share prices to fluctuate.
Where can you check stock prices?
Stock prices are published online, and they are easy to find by searching for a company’s name or ticker symbol. For example, Amazon’s ticker symbol is AMZN. If you have a brokerage account, your brokerage may also list current stock prices.
Why do stock prices change after hours or over the weekend?
Stock markets are closed on evenings, weekends, and holidays, so you might expect that prices wouldn’t change between the close of one trading day and the opening of the next. However, it’s possible to buy and sell after hours through an electronic communication network (ECN), and those trades can shift prices significantly, creating volatility even when markets are closed.
How supply and demand work in the stock market
Supply and demand determine the amounts of bids and asks. When buyers see a stock as desirable and of high value, especially when the supply of shares is small, they raise their bids. In addition, sellers may feel certain they’ll be able to find a buyer for attractive, scarce shares, so they increase their asks. This combination of high demand and low supply yields a higher price.
But if a stock is less appealing to investors, or if its shares are too plentiful, buyers aren’t willing to pay top dollar. Sellers must lower their asks if they want to make sales. Low demand and high supply often lead to lower stock prices.
The rate and amount by which a stock’s price fluctuates depends on many factors. Some events, however, can cause big spikes or dips. For example, the release of a ground-breaking new product could suddenly increase demand, enticing buyers to pay more and prompting sellers to raise their asks. On the other hand, a very bad earnings report could cause demand to plummet, motivating sellers to drop their asks and buyers to reduce their bids. The effects of these circumstances can be magnified by investor behavior; if a company’s stock price shoots up because people are suddenly buying up shares rapidly, the resulting low supply might push the stock price even higher.
Example of supply and demand
Berkshire Hathaway’s class A stock (BRK.A) is a clear example of how supply and demand can drive stock prices. Far and away the most expensive stock in the US, a single share of BRK.A cost almost half a million dollars in June 2022. Here’s why:
- High demand. The company is a massive conglomerate valued at over $275B, with a track record of success extending back to the 1830s. The famed Warren Buffett is its CEO. Investors believe shares will retain their high value and grow steadily.
- Low supply. Most companies increase the supply of stock by splitting their shares as stock prices rise so that more investors can afford to buy their stock. Apple, for example, has split its stock five times. BRK.A has never split, so the pool of stock available for sale is relatively small.
Factors that can affect stock prices
Many factors affect buyers’ and sellers’ perceptions about what a stock is worth, and, consequently, their bids and asks. They consider the company’s performance, as well as the larger context, including domestic and international conditions that could affect its stability. Investor psychology also plays a role.
Company news and performance
A company’s achievements and stumbling blocks affect demand. For instance, when companies fail to live up to their earnings projections, their stock prices usually fall. When they meet or exceed them, their prices often get a bump. A highly-anticipated corporate acquisition can increase demand, whereas product recalls or lawsuits can cause stock prices to plunge.
Supply-chain issues, new regulations, departure of key executives, and company misconduct, like Facebook’s Cambridge Analytica scandal, can also drive share prices down. Other key indicators include revenue, net income, and price-earnings ratio.
A company’s performance relative to others in its sector can influence demand for its stock. Some experts believe that sector stock prices move in lockstep. Thus, if one energy company has a negative outlook, investors will see energy stocks in general as less inviting. Other commentators, however, suggest that a single poor performer incentivizes buyers to shift their investments to other businesses in the same sector.
People’s desire to buy or sell stock is also affected by the larger economic context, producing markets that are more bullish or bearish. Economic components of demand include:
- Inflation: Sudden or significant inflation tends to cause stock price drops. Businesses’ dollars aren’t going as far, and neither are their customers’. This prompts investors to be more particular about the stocks they buy or invest less, decreasing demand overall.
- Deflation: Deflation tends to depress demand. Frequently, people invest to make sure earnings on their wealth outpace inflation. When every dollar is suddenly worth more, they have less incentive to accept the risks of investing.
- Interest rates: The Federal Reserve, or the Fed, uses interest rates to control inflation. When inflation is higher, it raises interest rates to amplify demand, which can increase investors’ returns. If the economy is trending towards deflation, the Fed lowers interest rates to stabilize prices.
- Recession: During recessions, stock prices can fall dramatically. As businesses struggle and incomes decrease, demand falls off. Stock prices typically follow, although they may rebound as the recession wanes.
- Trade wars: In a trade war, one country raises tariffs and limits imports from another to gain a political or economic concession. In general, trade wars lower stock prices, although they can be beneficial for domestic policy, businesses, and workers.
Wars, natural disasters, terrorism, and even exchange rates can influence companies and their investors, though the impacts are unpredictable. The 9/11 terrorist attacks in New York City, for example, were followed by a significant overall drop in the market. Hurricane Katrina’s immense devastation in 2005, however, had little impact. In fact, the materials sector, battery manufacturers, and others often profit in the wake of natural disasters. Finally, foreign exchange rates affect the cost of doing business in a country, which impacts business profitability and the share price buyers are willing to pay.
Investor confidence, or market sentiment, is an important part of how stock prices are determined. For example, early in the Covid-19 pandemic, chaos was widespread, and investors became extremely hesitant. This caused a huge short-term drop in the market, which some commentators believe was unwarranted given actual economic conditions. Human psychology inevitably comes into play when people invest their money, and the tendency to defer to herd mentality can contribute to market conditions, depending on the general tenor of the public’s sentiment at any given time.
Will stock prices go up or down?
Financial experts frequently speculate about the direction a stock is going, but there are too many elements in play to know precisely what price a given buyer and seller will agree on. Even when the market as a whole is trending up or down, individual stock prices vary widely.
That’s why many investors choose a buy-and-hold strategy, building diversified portfolios aligned with their risk tolerance and choosing investments that have historically performed well over the long term. While no investment strategy is without risk, buy-and-hold can help investors ride the waves of rising and falling stock prices.
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