Stock prices are determined by more than simply supply and demand. Understanding how the market works will help you get the best deal.
Look up how a stock price is determined and most sites will tell you it’s supply and demand. It’s an overly simple answer because most bloggers don’t understand how the stock market works.
How the stock market works is more complicated, but it doesn’t have to be a mystery.
The good news is that once you understand how a stock price is determined, it will help you make better investing decisions. It will help you avoid one of the biggest misconceptions in investing and can even help you compare stocks.
Let’s look at how stock prices are determined before blowing the lid off an investing strategy that loses money and sharing a few ideas on finding stock values.
How Does the Stock Market Work?
It’s true that once a company lists its shares on an exchange like the New York Stock Exchange or on a digital exchange like Nasdaq, there are a limited number of shares for the demand. If there’s a lot of people wanting those shares then they’ll have to offer a higher price to current owners.
When you buy or sell a stock, you do it through a broker which is just a company authorized to make the transactions. Brokers pay to have a ‘seat’ on the exchanges or the right to buy and sell directly in the stock market.
Compare the best online brokers with this list of online investing sites.
Brokers hire traders that do the actual buying and selling on the exchange floor. When a broker gets an order from a customer, they pass it through to a trader that either buys or sells the shares from someone else on the exchange. Brokers and their traders have to analyze all available information to determine how much a stock is worth at a moment’s notice.
There are also people called market-makers for each stock that have the obligation to make sure there is always someone to buy or sell a company’s stock. These people have designated places on the exchange where traders can go to guarantee they can buy or sell a stock.
None of this means a stock price is determined at a set price. That’s up to what these brokers, traders and market makers think the stock is worth.
Traders and brokers have a responsibility to get their client the best deal for a stock. Most of the time, this means getting shares for a price that is as close to the last price it was traded for in the market.
If new information comes out about the company, they have to decide what it means for the company and adjust the price they’re willing to pay instantly.
Why Stop-Loss Orders May Be Worthless
A popular investment strategy among stock traders is to set stop-loss orders on their positions. This means setting an order to sell a stock if the price falls below a certain point. Hence, putting the order in ahead of time can help to ‘stop the loss’ when the price falls.
Stop-Loss orders can be a good tool for traders that are buying and selling their stocks in less than a day or on just pennies of difference in the stock price but they are all but worthless for most investors.
It sounds great, set a price to sell the stock if it starts dropping. That means limiting your big losses, right?
The problem is how stock prices fall when they fall big.
When news comes out against a company or the market decides it’s going to panic, stock prices don’t fall gradually. The price of a stock doesn’t hit every dollar amount lower when it drops. Instead it drops all at once, losing double-digits.
Remember that stock prices are determined by buyers and sellers in the market. If news that a company just lost a lawsuit hits the market, buyers are not going to be willing to pay anything close to the last price.
Brokers and market-makers in a stock make a split-second decision how much the stock is worth and adjust the price automatically, usually sending shares down much lower than they should.
That means your stop-loss order is going to trigger at that low price, not at the price you set on the order. There was nobody that wanted to buy your shares at that order price.
Let’s look at an example. Say you have shares of Facebook, trading at $120 each and don’t want to lose more than 5% if the stock starts falling. You set a stop-loss for $114 per share thinking that will get you out if Facebook falls on hard times.
Then news hits the market that the European Union is regulating Facebook content. Brokers on the floor of the stock exchange decide that’s going to hit earnings by at least 30% and won’t offer more than $84 per share which is now the new price for the shares.
Your stop-loss order is triggered and the shares are sold for $84 per share on the knee-jerk reaction and you just lost 30% rather than the 5% at which you set the order.
This kind of stock trading tool just doesn’t work for regular investors.
How to Compare and Value Stock Prices
There are dozens of ways to compare and value stock prices, none of them perfect and some of them based more on fiction rather than facts.
As a long-term investor, you don’t need to be exact on a stock’s value down to the penny. Instead, understanding how stocks compare against each other and which may be undervalued should be your goal.
That’s quite a bit easier and can be done with just a few techniques.
- The Price-to-Sales ratio is easy to calculate and a lot better than the commonly used price-earnings ratio. Earnings are easily manipulated by management trying to make the company look better than it is while sales are harder to fudge. Dividing a stock price by the annual sales per share gives a purer picture of valuation.
As with all valuation metrics, you want to use the price-sales ratio to compare against the industry average and the five-year average of the company itself. It won’t tell you if a stock price is undervalued but it will tell you if it’s cheaper than competitors or it’s own history.
- The Price-to-Earnings versus Growth Ratio (PEG) is found by taking the P/E ratio of a stock and dividing by the annual earnings growth. It was suggested by Peter Lynch, a legendary investor that beat the market for nearly 30 years and is much better than just the price-to-earnings alone.
Investing only in low P/E stocks would put you in stocks of telecom and utility companies and avoiding higher-growth sectors like technology or health care. The PEG ratio gives you another piece of the puzzle by adding the growth in earnings. You can still invest in higher P/E stocks as long as the growth rationalizes it.
- One technique I use to value stock prices isn’t commonly used but has helped me produce solid returns. I follow the annual return for each of the nine sectors and average those returns over 20-years.
The idea is that stock market returns for each sector tend to be pretty consistent over long periods. Earnings growth within a sector may rise or fall with the business cycle but are smoother over the whole cycle and you remove crazy investor enthusiasm by taking the longer-view.
So, I buy more in years when a sector underperforms its longer-term average and avoid that group of stocks when it outperforms. Eventually, investor sentiment and earnings come back to the sector and stock prices head higher. It’s an easy way to buy-low without having to time the stock market.
This method doesn’t work as well for picking stocks of individual companies because earnings growth changes over a period of years but is a great way to plan your sector-level investments. From there, you can pick the best stocks from the sectors in which you want to invest.
Understanding what determines stock prices and some of the misconceptions can go a long way in being a better investor. Knowing how stocks are traded and some common ways to compare stocks will help you make better investing decisions and not get caught in some of the myths that lose money.