How are stock prices determined?

Equity markets are renowned for their ability to generate wealth over time. As a result, it garners a great deal of interest from individuals seeking to invest their savings and earn returns on their investments. Thus, the issue arises: how are stock prices determined? 

Economics at play

Demand and supply play a significant role in determining stock prices. Demand is the number of shares that investors wish to acquire, while supply is the number of shares that investors wish to sell. When demand and supply meet at a particular price level (equilibrium), i.e. when both consumer and seller agree to trade at a particular price point, price discovery occurs. A continuous price increase is known as an uptrend, while a continuous price decrease is known as a downtrend. Bull markets are characterized by sustained price increases, while bear markets are characterized by sustained price declines.

 
Factors affecting demand supply 

Demand and supply of a company is influenced by its underlying activity. If a company's business is doing well, more investors will want to own a portion of the company's stock. The increase in demand causes purchasers to bid up the stock's price in an effort to convince sellers to sell. Consequently, the stock price rises. If the company is not performing well, investors will want to sell their shares, thereby increasing the supply.

The increase in supply causes sellers to bid down prices in the hopes of attracting purchasers, thereby reducing the price.Since the character of the business determines investor demand and supply in the market, it is essential that we comprehend the factors that influence a company's fundamentals.

 
Industry specific factors

Industry growth – This is a key driver for a company. Various situations include – 

Technological Innovation - From out-dated business models to new ones. Example – wired telephones to wireless mobiles.

Market penetration – Since housing demand is expected to rise steadily in India over the coming years, building materials is expected to do well.

Regulatory changes – Electric vehicles is expected to do well going forward due to government push towards clean energy.

Attractiveness of industry structure -  
Porter’s five forces framework is the ideal way to assess the attractiveness of industry structure.

Inter-firm rivalry - Higher the rivalry among existing companies, lower the industry attractiveness and vice-versa. Example: the Indian Wireless Telecom sector is a huge growth opportunity and currently has just 4 major players. Yet the rivalry between them is so intense that the players’ profits are on a declining trend.

Threat of new entrants - The higher the barriers, the weaker the threat and greater the pricing power of existing participants. Example: Automobile industry where established players have strong brand and technology are unlikely to see new entrants, implying steady growth in business.

Threat of substitute products or services – Higher the number of substitutes, higher the threat, thus the pricing power of existing participants is low. Example: Print media and Television sectors are gradually being substituted by the digital and internet media (like Youtube, HotStar, etc).

Bargaining power of customers - Lower the bargaining power of customers, higher the sector attractiveness and vice versa. If the number of customers are high, their bargaining power tends to be low, whereas if the number of customers are less they tend to have high bargaining power. Example: Cigarettes - customers are addicted to brand / products giving the manufacturing companies high bargaining power.

Bargaining power of suppliers - Lower the bargaining power of suppliers, higher the sector attractiveness and vice versa. If the no. of suppliers are high, their bargaining power tends to be low, whereas if the no. of suppliers are low, they tend to have high bargaining power.

Company specific factors

Competitive Advantage – Companies that have created a competitive advantage typically perform well over time. Example: strong brand (Coca-Cola, Asian Paints), distribution network (HUL, Maruti), nigh monopoly (ITC) or technology (Apple).

Business model – The business environment is in constant flux. A company's business model must be adaptable enough to accommodate any business changes in order to be successful.

Quality of Management – Strong management is likely to steer the company toward profitable, long-term growth. Consequently, management plays a crucial function. Recent management changes at Infosys have kept the market interested, as the new CEO will be responsible for the company's future development.

Healthy financials – Whatever a business does will ultimately be reflected in its financials. If a business is performing well, its financials will be sound. This is evidenced by the company's consistent revenue growth, high operating and profit margins, and healthy cash flow. A company with strong financials will earn a larger return on the equity / capital employed (RoE / RoCE) than is required by the business. This is a crucial metric; if a company can generate a higher RoE/RoCE, there will be a great deal of demand from investors for its stock.