So what exactly is behind a “share price”, and how is it worked out?

Back in the old days, and as recently as 1990s, the main way of finding out how your share portfolio was doing was through the morning’s broadsheet newspaper.

If you go as far back as the 1920s, broking houses would print out physical price tickers (think of an old film reel).

During the crash of 1929 there were stories of brokers’ assistants staying up all night to find out how much money the firm had lost because the machines were taking hours and hours to print out all the prices of transactions.

It hadn’t improved much by the 1980s because those same assistants would have to run across the road with contract notes to facilitate settlement.

That’s one of the many reasons why we have CBDs – it makes physical contract exchanges rather convenient.

Printed on these contract notes (now in soft copy) is the exact price in which you purchased the stock. And just to be clear the words “stock” and “share” mean somewhat different things, but can generally be used interchangeably.

A “stock” is the collective term for the asset listed on the share market. That asset, or stock, is made up of thousands, or millions of “shares”.

Others may beg to differ on this definition but it makes sense to me. I’m happy for someone to argue otherwise.

So what is the share price?

The share price is the value of a company as determined by shareholders, or the market.

We live in a free-market, capitalist economy.

That means the market, made up of “rational” (of sound mind) “agents” (people), or “buyers” and “sellers”, are free to compete with one another for assets (or stuff they think they’ll benefit from by owning).

So if a particular stock is heavily sought after (in other words a lot of people decide they’d like to ride on the back of a company’s success) they’ll be climbing over one another to buy shares in the company.

Naturally the price will then start to rise as the people outbid each other to get “in” to the stock as soon as possible. The higher the price goes the more value the market places on the company.

Generally speaking, the bigger and more powerful the company is, the higher its stock price. The smaller and weaker the company is, the lower its stock price.

How exactly is the price determined?

Well do you want the easy answer or the ridiculously complicated one? The easy answer is: you do! In the world of discount stockbroking you’re perfectly entitled to jump on your laptop or PC and bid for a stock.

Consider this: you see a stock like BHP Billiton (BHP) and think to yourself, ‘am I prepared to pay between $18 and $20 for units in the company?

If the answer is ‘yes’, then great. If the answer is ‘no’, then – assuming there are other people thinking like you – there will be pressure on the price to fall (if you don’t think it’s worth as much as $18), or pressure for it to rise (if you think you’re getting a bargain).

The hard answer looks at mathematically valuing the company. Actually doing this is quite complicated. Understanding what’s involved though is not so complicated.

I’ll explain it briefly here. The main method used by stock (or equity) analysts is called Discounted Cash Flow (DCF) analysis.

Simply put, mathematicians or analysts try to work out how much money is going to be transferred into and out of a business over the next 5 or so years.

That’s a hard task when you don’t work for the company, or have anything to do with it! They then use a mathematical model, or equation, to “discount” those cash flows to find the company’s “present value”.

Think of it like this: no one wants to own the past – it’s been and gone. What you want to do is own the future. You want to know that what you’re buying today is still going to be viable in five years’ time.

So analysts try to predict how a company will perform into the future, take a snapshot of what the company looks like in a few years’ time, and then use mathematics to rewind that future value back to the present day. The formulation literally spits out a stock price.

Value versus price

Some investors choose to own stocks because of the dividends that come with them. If you own a lot of shares it can be quite lucrative.

Others though are keen to make a “capital gain” (buy the stock, watch the price rise, and then sell the stock at a higher price).

So here’s the thing: if you can work out the true value of a stock (often through DCF analysis) and you find out that the value of the stock is in fact much higher than its current price (what it’s trading at), well then you have yourself a bargain!

In other words, the price of a stock is what the market determines at any particular point in time. The value of a stock is how much it’s objectively work, based on the company’s forecast cashflows.

Results and expectations

Another quirky aspect of share price determination is highlighted during the company reporting season – when the executives deliver the company’s half year and full year results.

To put it really simply, it’s all about expectations. Stockbroking houses use their analysts to determine what the company is likely to say when it announces its profit result, and, ultimately, the value of the stock.

If the CEO of the company reveals a number that is better than what analysts had been expecting, the stock price will rise. The reverse also happens.

To emphasis the point though, it explains why a stock price suddenly rises when a company announces a loss! If that happens it’s simply because the market/analysts were expecting an even bigger loss than what was announced.

Volatility

I can’t leave this topic without talking about volatility. Stock prices are sensitive to news and market psychology.

Generally speaking stock prices don’t swing too much, but when the market experiences a shock (like 1929, 1987, or 2008/2009) investors become hyper-vigilant for years afterwards, and the smallest surprises can throw the market into a tailspin.

Be aware that when you invest your money in shares, the prices of those stocks may swing wildly at times as the market, and analysts, try to work out the company’s true value. When that value is determined, the market rests, but only for a moment.                                                                                                                                                           

This should not be considered financial advice. It is general in nature only. I have not taken into account your personal financial situation or your risk tolerance.