Stock Prices! The most important figure in investing, but how do they work?

While there are many things we look at when investing, at the end of the day the price of a share is all that matters.

Have the stocks we invested in gone up or down?

No matter, earnings per share, revenue or growth potential. The company’s stock price is the final indicator that matters to all investors.

Yet most investors don’t even know how these prices are determined, or what makes them change. Not even to mention how stock prices between different companies can be compared…

Let’s have a look.

What causes stock prices to change?

The stock market is driven by supply and demand.

Whenever a stock is sold, a buyer and seller exchange money for share ownership in a company. The price for which the stock is purchased becomes the new market price of the stock.

When another share is sold, this price becomes the newest market price.

So, for large companies where thousands of transactions take place between shareholders every day the stock price can change thousands of times. Because of these many transactions the changes in price tend to be smaller.

For smaller companies where less shares change hands every day it works differently.

Less transactions mean it is slower, and more difficult to match up buyers and sellers. Consequently, the changes in share price tend to be bigger in between transactions.

This happens either as sellers are hard up to sell a share, and willing to take less from a buyer. Or as buyers are clamoring to buy shares, willing to pay higher prices to sellers that might be few and far between.

Understanding the supply and demand part is simple.

What is difficult to comprehend is what makes people like a particular stock and dislike another stock.

This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the theory is that the short-term price movement of a stock indicates what investors feel a company is worth – the longer term price movement is a reflection of the deeper seated value of a company. We often call this intrinsic value.

So how does the value of a share compare to its  stock price?

I’m sure you’ve heard the term “Price is what you pay, value is what you get”.

So, in terms of a company with shares you invested in this is what it means:

Let’s take a look at Trematon, as an example.

Trematon’s last traded share price was 250c per share. The company has 222,774,248 shares in issue. That means the entire company has a market value of over R556 million.

But when you look at Trematon’s assets and liabilities you’ll find the company is worth around R755 million right now. That is, if Trematon sold all of its investments it would raise over R755 million. Investors would get a premium of around 32% on the current share price if the money was paid out to them.

This value is called the intrinsic value. That means it is the ‘internal’ value of the company. Over the long term, ignoring sentiment, we’d expect the share price and the intrinsic value to be close to one another.

But in times of positive sentiment share prices often overshoot the intrinsic value because of investor euphoria and the belief that growth will continue to stay higher forever.

And in times of negative sentiment, share prices are often much lower than intrinsic value because investors are despondent and have basically given up hope.

So, what affects the sentiment for a stock?

Sentiment for stocks are affected by a number of factors:

Political sentiment affects the outlook on a sector – if a law change such as expropriation or a new mining charter is on the horizon it slows investor appetite due to uncertainty about what the law holds for the future. This could affect the agriculture or mining sectors for example causing bad sentiment.

New technology or discoveries – New technology can create both good or bad sentiment for a sector. Think of something like streaming video. It created an opportunity for companies like Netflix and Youtube to become multi-billion dollar businesses. But it also decimated the video rental industry. Investors often latch onto these new technologies and stocks in these sectors outperform (or underperform) massively. Sometimes sentiment gets carried away creating exaggerated movements in share price. Over the long term this will correct however.

Short term news announcements – The announcement of a coming dividend, earnings growth or impending losses can affect the sentiment towards a share. Many times, the effect of this is exaggerated in the short run, and corrects over time as investors digest the information unemotionally.

How do you compare the values of companies and stocks to one another?

One mistake I often see investors make is directly comparing the share prices of companies. You cannot do that.

Let’s look at Redefine and City Lodge as an example.

Redefine’s share price is R4.90 today. City Lodge’s share price is R4.61.

Does that mean these two companies are valued nearly the same by the stock market and its investors?

No.

You see, City Lodge has a total market value (also called Market Capitalisation) of R2.7 billion.

Redefine on the other hand has a market capitalization of R34.7 billion.

That is, even though the two companies have similar share prices, the one is worth over 12 times more than the other.

How’s this possible?

Well, companies don’t have the same quantity of shares in issue.

So, Market Capitalization = Share Price x Shares in issue.

That’s why we use figures like earnings per share, PE ratio, Net asset Value per Share etc.

It gives us a way to evaluate a company’s performance relative to its shares.

The most important things to remember from this are:

1. At the most basic level, supply and demand determines the market price of a stock

2. Price times the number of shares outstanding is the value of a company. Just comparing the share price of
two companies is useless.

3. Earnings and the value of assets theoretically point towards the value of a company. But due to sentiment
investors don’t always objectively consider this.

There is no single theory to explain anything in the stock market. Things are always changing – and using your
knowledge, you always need to adapt.