How are stock prices figured?

Question

I may seem like an idiot for even asking, but why do stock prices go up and down? You'd think that since investors always want to make a profit, they'd never sell for a loss. I always thought that in the end, the owner of the shares determined the price he sells his shares for...or am I wrong? If that's the case, why would he ever make a deal for less than he bought the shares for?

I know I made that overly confusing, but I'll attempt to simplify: Who sets the price when shares of stock are bought/sold? Are people buying shares from other investors, or from the company directly? Why do stock prices ever go down?

Answer 1

I'll try to keep this short:

A stock is a partial ownership of a company. So let's say a million people want to buy a company together and the company is worth $5 million dollars. The company gets "taken public" or sold to the public through shares of stock and the million people each buy 1 share of stock (in our example) for $10 per share.

Now let's say the company does poorly and it becomes worth less, let's say it's now worth $5 million. As people are trading shares of stock back and forth, they are only going to be willing to trade them at $5 per share. If the company grows and becomes worth more (ie. becomes more profitable or makes more sales), investors will be willing to buy and sell shares of stock at higher price. At the end of the day, if the company ever gets bought out or decides to liquidate, there is an assumption that investors will get back the value of their stock from the sale or the liquidation of assets (like buildings, inventory, etc). So if you buy a stock, you generally expect the company to grow and do well and make the value of the company (and hence your stock price) to go up.

Another reason stocks have value is because many companies pay dividends. If you hold $10 of stock and the company pays a $1 dividend per year, you (as a part owner and sharing partner in profits) just earned 10% on your money.

I'm trying to keep this simple, but there are many ways to value companies through models and the like, but it all comes down to how much is/will the company be worth.

If a company reports low earnings after you buy it, the stock price will fall. If you think the company will continue to perform poorly and do even worse, you would want to sell your stock to avoid further losses. If you think people are under-valuing a stock, it's usually a good time to buy.

So, I know that was lengthy, but I honestly hope it helps you understand the process.

Answer 2

Stock pricesa are determined by a formula called the Dividend discount model, which takes into consideration, the dividend, the return on equity calculated using Capital Asset Pricing model, the growth rate, a time horizon says 5 years etc;. Actually the axiomatic reason for such a formula is, the numerator of the dividend discount model represnets the strategic imperatives of the company and the denominator describes the Management efficiency. In fact some puritans use the weighted average cost of capital for denominator instead of cost of equity. This formula when applied fixes the upperbound of the stock value at any given time.
Now the market has different palyers, like the Bulls, the Bears and Arbitragers. Their inter play in the market keeps the price on a legitimate tragetory. When the price is low the Bulls keep buying the stock. When it crosses the legitimate limit the price we calculated the Bears short sell brininging the price down to the theoretical highest value calculated above and if there is any short term price discrepency the Arbitragers interfere and correct these short term price differentials and restore the normal price. What the Arbs do is called 'scalping'. This is how the market determines the price level and keep fluctuating as the interplay between these players take place everyon hoping to make short term profits.

Answer 3

Have you ever gone to a garage sale? The homeowner labels something at $5.00 but haggling is part of the game. You bid $3.00, he comes back and asks $4.00 and so on until you reach a mutually agreeable price. This is basically how the stock market works.

If you look at a quote on Yahoo or elsewhere, you'll see a bid price and an ask price. The bid price is what a buyer is offering and the ask price is what the selling is asking. If they aren't the same, then no trade is made. The buyer has to come up or the seller has to come down.

Alternately, as the buyer you could say I'll pay market price and you'll pay whatever the seller is asking. The seller could also be desparate to get rid of the shares and will take whatever the market will give him so he takes whatever the seller is offering.

When lots of people really want to own that stock, the sellers will keep increasing their asking price. When lots of people want to dump their shares, the buyers will keep lowering their price.

In a nutshell, that's how it works.

Answer 4

Also try to remember that all buying and selling in ANY market is regulated by the simple economic laws of supply and demand. i.e. more buyers=higher prices/more sellers=lower prices. Sometimes stock prices defy the logic of earnings and are determined by the number of people or institutions buying or selling at any particular time.