Value investing pioneer Benjamin Graham once said that the stock market is a voting machine in the short run but a weighing machine in the long run.
Once a company goes public on the stock market and its shares start trading on an exchange, the share price is determined by supply and demand. But over the long term, share prices are determined by the economics of the business. It's impossible to predict exactly what a stock will do and when, but we can study how share price movement works. Let's unpack Graham's statement a little more and go over how stock prices work.
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How do stock prices work?
How do stock prices work?
It starts with the initial public offering (IPO). Companies work with investment bankers to set a primary market price when a company goes public. The price is set based on valuation and demand from institutional investors.
After the initial offering, the stock starts to trade on secondary markets -- that is, stock exchanges such as the New York Stock Exchange (NYSE) or the Nasdaq. This is where we get into the market being a voting machine.
For highly traded stocks, there are buyers and sellers on each side constantly bidding and asking for new prices. Institutions trying to build huge positions and even brokerages working for individual investors will bid for stocks. If there are more buyers than sellers, the price will get bid up. If there are more sellers than buyers, the opposite will happen.
That's why Graham called the market a voting machine. On a second-by-second basis, the price of the stock reflects what current buyers are willing to pay and what current sellers are willing to take. This might sound familiar if you took economics in college. It's the same principle for any commodity: The price is determined by supply and demand.
Definition Icon
Law of Supply and Demand
The law of supply and demand is an economic theory asserting that supply and demand will meet each other at a certain equilibrium price.
Understanding what determines stock price
Understanding what determines stock price
Now let's get to the weighing machine part. Over the long term, stock prices are determined by the earnings power of the business. Remember, a stock is a share of an actual business. The better the business does, the better the stock will do.
Graham's protege, billionaire investor Warren Buffett, says that a stock is worth the discounted value of the stream of cash flows it will earn over the life of the business. To get the valuation of the business, he will estimate the amount of earnings the business will make in the future and then discount the future years because money now is worth more than money you could get later on.
Often a stock will deviate from that valuation, however. If it trades for less than the value, it is considered undervalued. If it trades for more, it is considered overvalued. Eventually, the stock price reverts to the value as the market weighs the stock price based on the earning power of the business. Investors who look to take advantage of deviations by buying undervalued stocks and shorting overvalued stocks are called value investors.
How market cap affects price
How market cap affects price
The market cap of a stock is equal to the total shares times the share price. It's the price it would take to buy all of a company's outstanding shares. Many stocks issue more shares to fund the business, so it is important to base valuation on the market cap and not just the stock price. The more shares that are issued, the less of a fraction of the business you own.
On the other side, if a business buys back shares, the price of each one of your shares will need to go up to maintain the same market cap. Share buybacks are generally cheered by shareholders as long as the stock price isn't overvalued.
How to tell if a stock is "cheap"
How to tell if a stock is "cheap"
We don't have the space here to do a full-blown discounted cash flow analysis as Buffet would like, but we can use a shortcut. The price-earnings ratio (P/E) shows the price of the stock relative to earnings. It's calculated by dividing the stock price by earnings per share. Earnings per share is a readily available number on most financial websites and the company's quarterly reporting documents.
Let's look at Home Depot (HD -0.85%) as an example. As of May 2023, Home Depot was trading at $291 per share, and its earnings per share over the past 12 months were $16.68. That's a P/E of 17.44.
That number doesn't mean much by itself, so we need to compare it to its historical numbers. Over the past five years, Home Depot has averaged a P/E of 22.96, which is above the current valuation.Because the P/E average had been higher than the May ratio, Home Depot could be an attractive stock investment. Value investors tend to look for stocks with lower P/E ratios.
Definition Icon
Bid and Ask
Bid and ask are two points of a price quote. Bid is the price investors will pay for an asset, while ask is the price they’ll sell it for.
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3 Most Important Financial StatementsWhen researching companies, the financial statement is a great place to start.
In the short term, the price of a stock is vulnerable to the emotional whims of the crowd. But, in the long term, smart investors can pinpoint where the emotions of the crowd set up opportunity. Focus on the long term in your investing, and don't let other people's emotions affect your investment decisions.
Lou Whiteman has positions in Home Depot. The Motley Fool has positions in and recommends Home Depot. The Motley Fool has a disclosure policy.
FAQs
Once a company goes public on the stock market and its shares start trading on an exchange, the share price is determined by supply and demand. But over the long term, share prices are determined by the economics of the business.
How exactly do stock prices get determined? ›
What determines stock prices? The price of a stock is largely determined by supply and demand. If demand is high, the price tends to go up, and if supply is high, the price tends to go down.
What is the most accurate stock predictor? ›
1. AltIndex – Overall Most Accurate Stock Predictor with Claimed 72% Win Rate. From our research, AltIndex is the most accurate stock predictor to consider today. Unlike other predictor services, AltIndex doesn't rely on manual research or analysis.
How is a stock price determined in real time? ›
Exchanges calculate a stock's price in real time by finding the price at which the maximum number of shares are transacted at the moment. The price changes if there is a change in the buy or sell offer for the shares.
Does Motley Fool stock advisor tell you when to sell? ›
Yes, The Motley Fool will tell you when to sell a stock. Over these 8 years they have issued 18 sell recommendations. Four of these sell orders have been because the companies were being acquired and they recommended selling to get the cash out.
What is the algorithm that determines stock prices? ›
To put it simply, the price of a stock is determined by supply and demand. If more people want the stock than the number of shares available, the price goes up. Conversely, when lots of people are looking to sell their shares, the price of the stock falls.
Who decides how much a stock is worth? ›
Once a company goes public and its shares start trading on a stock exchange, its share price is determined by supply and demand in the market. If there is a high demand for its shares, the price will increase.
What is the best algorithm for predicting stock prices? ›
The LSTM algorithm has the ability to store historical information and is widely used in stock price prediction (Heaton et al. 2016). For stock price prediction, LSTM network performance has been greatly appreciated when combined with NLP, which uses news text data as input to predict price trends.
Which is the most successful stock indicator? ›
Seven of the best indicators for day trading are:
- On-balance volume (OBV)
- Accumulation/distribution (A/D) line.
- Average directional index.
- Aroon oscillator.
- Moving average convergence divergence (MACD)
- Relative strength index (RSI)
- Stochastic oscillator.
We screened 69 titles and read 43 systematic reviews, including more than 379 studies, before retaining 10 for the final dataset. This work revealed that support vector machines (SVM), long short-term memory (LSTM), and artificial neural networks (ANN) are the most popular AI methods for stock market prediction.
This method of predicting future price of a stock is based on a basic formula. The formula is shown above (P/E x EPS = Price). According to this formula, if we can accurately predict a stock's future P/E and EPS, we will know its accurate future price.
Are stock prices truly random? ›
Random walk theory suggests that changes in asset prices are random. This means that stock prices move unpredictably, so that past prices cannot be used to accurately predict future prices. Random walk theory also implies that the stock market is efficient and reflects all available information.
How do I know if a stock will go up the next day? ›
Some of the common indicators that predict stock prices include Moving Averages, Relative Strength Index (RSI), Bollinger Bands, and MACD (Moving Average Convergence Divergence). These indicators help traders and investors gauge trends, momentum, and potential reversal points in stock prices.
What is the rule of 72 Motley Fool? ›
Let's say that you start with the time frame in mind, hoping an investment will double in value over the next 10 years. Applying the Rule of 72, you simply divide 72 by 10. This says the investment will need to go up 7.2% annually to double in 10 years. You could also start with your expected rate of return in mind.
What is the 3-5-7 rule in trading? ›
The 3–5–7 rule in trading is a risk management principle that suggests allocating a certain percentage of your trading capital to different trades based on their risk levels. Here's how it typically works: 3% Rule: This suggests risking no more than 3% of your trading capital on any single trade.
Is it worth paying for Motley Fool? ›
For investors looking for stock ideas and actionable guidance, Motley Fool is likely worth the reasonable annual fees. The stock research alone can pay for the membership cost if you invest in just a couple successful picks. However, more advanced investors doing their own analysis may not find sufficient value-add.
How is price decided in stock market? ›
In India, the share price is decided by the supply and demand. The supply is the total number of shares, while demand is the number of shares that investors are willing to buy at a given price.
How is stock listing price determined? ›
The listing price is the price at which the shares trade on a stock exchange after the IPO. First, the issue price is set by the company, while the listing price is determined by supply and demand in the market.
How do you determine the real price of a stock? ›
The most common way to value a stock is to compute the company's price-to-earnings (P/E) ratio. The P/E ratio equals the company's stock price divided by its most recently reported earnings per share (EPS). A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value.
How is the stock price determined formula? ›
Earnings Per Share (EPS) is a crucial financial metric that plays a significant role in determining a company's share price. EPS is calculated by dividing a company's net earnings by its outstanding shares, representing the portion of profits attributable to each outstanding share.
