How does the stock market work? How are stock prices of a company decided at particular times, and what factors are responsible for its high and lows?

How does the stock market work? How are stock prices of a company decided at particular times, and what factors are responsible for its high and lows?

 

TL;DR:"The market is a voting machine in the short term." However, in the long run, the market is a weighing machine." Ben Graham's[1]

Part 1: How Does the Stock Exchange Work?

Part 2: How Should Stocks Be Valued?

History: Once upon a time, humans managed businesses only with their own money. They ran modest enterprises that they expanded solely via their own profits. However, not every business can be started using your own money. Imagine if you wanted to construct an entirely new plant that would cost over a million dollars? Banks will not lend money to young businesses, and your friends will not have that much.

In many september-16th centuries after Europe began to explore Asia as well as the Americas, the large explorers felt they required a great deal of cash since their monarchs were not paying them anymore. The wealthy folks expected plenty of interest. As a result, they felt the necessity to raise funds from quite a few ordinary people. Consequently, by 1600, the Dutch East Indian Corporation became the initial entity to list its shares on the stock exchange of Amsterdam and trade them continuously.

In many september-16th centuries after Europe began to explore Asia as well as the Americas, the large explorers felt they required a great deal of cash since their monarchs were not paying them anymore. The wealthy folks expected plenty of interest. As a result, they felt the necessity to raise funds from quite a few ordinary people. Consequently, by 1600, the Dutch East Indian Corporation became the initial entity to list its shares on the stock exchange of Amsterdam and trade them continuously.

What exactly is a stock? Stocks in a firm give you a piece in its future profits in exchange for your money's worth. For example, if you buy one Apple stock now, you will be promised one-billionth of Apple's future profits (since Apple has issued nearly a billion such stocks).

Listing: Thousands of businesses are listed in a stock market, and these companies (known as public corporations because they have distributed their shares to the people as a whole) paid a fee to the stock exchanges in exchange for a guarantee to supply all necessary information to the markets. In exchange, they will be able to list their company on the stock exchange's board and receive funds from market visitors. An initial public offering (Initial Public Offer) is the initial occasion a company's stock is listed on the stock exchange's board.

Brokers: An stock exchange is conceptually comparable to eBay. These folks allow businesses to get listed and connect buyers and sellers. Because there are millions of people trading on the marketplace and since it is nearly unattainable to these exchanges to be able to deal with all of them, they have appointed brokers to act as intermediaries for their platforms and the individuals.

Part 2: How is a stock valued?

Terminology for Beginners:

We shall use the word EPS (Earnings per share), which means exactly what it sounds like. It is the company's profits divided by the number of shares. For example, Itunes has $41 billion in revenues and approximately 950 million shares, resulting in an EPS of approximately 41000/950 = $44/share. As a result, once you own a share in the company your are entitled to 44 cents of the company's profits this year.

How to Calculate the Share Price:

To determine how much you should spend for that single Apple stock, simply total all the potential earnings you will receive.

Stock Price = Year 1 EPS + Year 2 EPS +...

You now comprehend that a single dollar earned ten decades hence tomorrow will not be identical as a greenback earned now. Because there’s an interest rate involved, and money in ten years is less valuable than money now. As a result, you must modify those formulae.

((EPS in Years a. )/(1+i))+ (EPS in Month 2/(1+i)2) + (EPS in Year 3/(1+i)2) +...

There is a lot of arithmetic involved (beginning with the compound interest formula), and for the purpose of simplicity, I will get to the final findings and limit the stock price to two scenarios:

1. In the situation of a mature corporation that fails to grow:

EPS/Interest rate = stock price

The predicted interest rate is quite simple to calculate and is determined by the riskiness of the company, the riskiness of the market, and the current long-term interest rate on government bonds. This interest rate is around 10% for numerous mature utility firms. As a result, utility firms that do not expand significantly are often traded at around 10-15 times EPS. (insert in the above formula).

The price of the shares of these kinds of businesses are remarkably predictable and change only when long-term interest rates change, the company's risk profile changes (can modify while tropical cyclones such as Sandy hit), or market danger changes (for example, the 2008 financial crisis).

2. For an increasing the business: stock price = next year's EPS / (that is, interest rate - company's predicted growth rate)

Let's look at a simple example. In the event assume Apple's Earnings will be $48, the predicted rate of interest for such a risk firm will be 15%, and the annual growth rate will be 5%, you will get:

The optimum value of the stock for the company is $48/(15%-5%) or $480/10%. Where did I acquire this mystical 5% figure?

So all pool our intellect to forecast the company's future growth and, as a result, its current price.

To make this communal prediction, we constantly collect new data and project it into the future. For example, if the company's management hires hotshot young engineers, we believe the years to come will be bright. What other kind of news do investors generally use:

1.       Regular financial outcomes of a business that provide us with insight into the company's operations and financial status.

2.       Periodic results from comparable businesses that assist us in predicting this company's results. As a result, when Apple sneezes, everyone else gets a cold.

3.       Changes in the industry. If a new survey shows that individuals are more likely to use mobile phones, we estimate that the rise of these businesses will be rapid.

4.       Changes in the whole market.

5.       Changes in the global economy

Market Estimation: In summary, we try to use all available information to forecast the company's future growth, then put this into our formula to determine the stock price. For example, if Apple releases a report indicating that consumers are buying less iPads, we may ding Samsung as well because we assume samsung Android Tabs will sell fewer as well.

Predicting growth rate is more of an art that a science, and it is done collectively by millions of people in a location named the stock market. Stock prices vary because we must constantly modify the growth rate depending on fresh information.

.The following are the main benefits of a stock market: 1. Starting/building an organisation: The stock market allows companies to raise funds from a wide number of people. That implies that one has more options for raising capital to start a firm.

2. Risk distribution: It allows you to distribute the risk of a firm to a wide number of people. Because each person invests only a small fraction of their income into the shares of a single business, the possibility of a single business collapsing has little impact on investors.

3. Value assessment as a group.

In summary, modern organisations necessitate a large amount of cash, which is out of reach for most people. Markets enable corporations to raise funds from a huge number of people, and these investors collectively value their company. According to the hypothesis, when a big number of people conduct independent valuations, the company's price approaches its optimum worth.

"The financial system is a political machine in the short term." However, in the long run, the marketplace is a weighing machine." -- Warren Buffett

(Disclaimer: This solution is intended for basic-intermediate level investors, rather than higher frequency traders or experts. To improve clarity, I purposefully approximated a few things).