How does the market determine the value of a stock?

 

Stock valuing understanding for beginners:

 

 

To start with, understand there is no clearly defined or singular method investors use to figure out what a stock is worth.

 

For example, in early 2015 Google was earning money and profits were growing, but the stock value was not increasing as rapidly as it had in the past with similar growth earnings. Compare this to Tesla, which has had several quarters of negative income, but has experienced immense stock price growth (even though they are operating at a loss). These companies stock prices display little relation to the cash generation of the companies themselves.

 

The basic rule of thumb for the future price of a stock is:

 

  • If a company will sell more then expected, at a higher profit, or expand considerably, the value/stock price will increase.
  • If a company (or the market overall) will sell less then the market expects, sell at a lower profit, have increased competition, or become obsolete in the future, the value/stock price will decrease.

 

There are, basically, three components to a stock’s perceived value to the market:

 

  • Historical and current stock performance and current company metrics (such as earnings per share, dividend payment)
  • The sector the company belongs to (such as technology, bio-development, or manufacturing)
  • Future expectations for the company and market

 

Historical/current company performance:

 

As discussed in the Stock Basics page, a stock is basically a piece of a company. Therefore, the value of a stock should be worth a given percentage of whatever the company is worth. Determining company value – and therefore the value of a stock – is not easy. Here are a few basic metrics most investors use to value a company, and therefore enable company performance comparisons:

Earnings per Share – A stock is a part of a company, the company should be making money, the earnings per share how much money the company brought in for each share issued. Basically, this is the income/# total shares.  This money is not money you get, it is just the income the company brought in for each stock (piece of the company issued).

Price/Earnings (P/E ratio) – This is just the price of the stock divided by the earnings per share. This is important because if we value the company based on income, if income goes up, we could see the value of the stock increase proportionally.

The ratios vary greatly by sector, typically high-technology firms have very high Price/Earnings ratios (meaning they bring in little money per share price); whereas low-technology companies, like manufacturing, have lower Price/Earnings ratios (meaning the money they bring in per year is closer to the share price).

 Application of Price/Earnings Ratio – Companies with high Price/Earnings ratios tend to be less-stable than companies with low Price/Earnings ratios. So if you are looking for more stable stocks, lower price to earnings ratios are desirable, but companies with high Price/Earnings ratios can experience much greater growth (and higher risks).

Dividend Payouts - Some stocks also pay dividends; the amount and frequency vary depending on the companies and goals. In some cases these dividends can be quite substantial, but in most cases your growth will come from the stock value growth, not dividend returns.

 

The sector of a stock or security:

Different sectors measure company performance differently. An internet-based company may make very little net profit, but be priced much higher than a manufacturing company turning the same net profit.

The sector of a company will greatly change the methods used, and what is considered, in the valuation of a company. When you are comparing companies, make sure you only compare somewhat similar companies (so compare Ford to GMC for example); if you compare companies that are not similar it is like comparing apples to oranges (a comparison between Google and GMC would have little meaning).

Example:

I can compare Anheuser Busch (NYSE:BUD) to  Coors (NYSE:TAP). Both operate in almost the same market, have somewhat similar Price/Earnings ratios, and pay similar dividends. I would not be able to directly compare Facebook (NASDAQ:FB) to Coors (NYSE:TAP) however, they are not in similar markets, or sectors, therefore comparing fundamentals would be meaningless.

 

Future Expectations for a Company:

How can we know the future of a stock, company, or product? We can not know what will happen, but a stock price can give clues as to how the market perceives the future of a company.

When valuing a stock, one of the largest components is future expectations for a company. This is why Tesla can be hemorrhaging money while maintaining a high stock price: they could grow to be the next Ford in the future, sell millions of cars, thus justifying the high stock price even though they are losing money today. This is also why a large number of stocks move with market expectations and economical forecasts: if the future looks good, the stocks are projected to grow (a rising tide lifts all ships).

 An example of how much future predictions can change the value of a stock:

There was a time when cell phones did NOT do GPS navigation, Garmin and TomTom made and sold GPS navigation units for this exact function. Then, Google announced it would start building GPS navigation into Android phones. With this, everyone who owned a smartphone would now also own a GPS. The share value for Garmin dropped 16% in a day and TomTom fell 21% in a day. See the New York Times article here.

 

All of these factors drive the market to determine what a security/stock is worth. But, in the end you will decide if the company will be worth more by buying a stock.

 

What does this mean for beginner investors in simple terms:

  • If a company will sell more, at a higher profit, or expand more than the market expects, the value/stock price, will increase.
    • This growth must be greater than market expectations (which are priced into the stock already).
  • If a company (or the market overall) will sell less, sell at a lower profit, have increased competition, or become obsolete in the future, the value/stock price will decrease.
    • If there is a negative outlook the market as a whole, this can cause stock prices to drop also; as the worsening market will shrink sales, and therefore make the company worth less.

These are the fundamental rules of the stock market - keep these in mind when buying/selling stocks.

Article by Jacob K Lloyd

Jacob@startingwithstocks.com

Published: 3 July 2015

Last updated: 13 Sep 2015

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