Many investors start their journey into stock investments by understanding the process of determining share prices. Stock values are not fixed and the fluctuations in prices are influenced by the demand supply dynamics of the market.
Stock exchanges determine a stock's real time price by identifying the point at which the highest volume of shares is currently being traded. The price adjusts in response to any changes in the buy or sell offers for the shares. Let's begin by understanding how the intrinsic value of a share is calculated.
Key Highlights
Investor perceptions and overall market sentiment can impact share prices.
Traders use charts, trends and historical data to predict future price movements.
Higher liquidity and trading volume often lead to more stable and accurate pricing.
Determining the intrinsic value of the stock
To determine whether a stock is priced too high or too low, it is essential to understand its fair or intrinsic value. In the decision making process, intrinsic value (IV) holds significant importance and aids investors in calculating potential returns.
Numerous crucial internal and external factors impact the market price of a stock. Developments within the company, shifts in demand and supply, and macroeconomic conditions all contribute to influencing the stock price. This suggests that stocks traded on exchanges may not consistently reflect their true value.
Opting to purchase stocks at their fair value enhances the likelihood of securing better returns on investments. However, lacking awareness of a stock's fair price can lead to paying an inflated amount. Intrinsic value (IV) serves as a vital tool, enabling investors to understand the difference between a stock's accurate price and its value influenced by market conditions.
Methods to Determine Intrinsic Value
A stock's intrinsic value is essential for making informed investment decisions. Let's understand several methods that offer distinct perspectives and applications in determining this intrinsic worth.
- Dividend Discount Model (DDM)
The DDM involves determining the total present value of a company's anticipated future dividends. If the resulting stock prices exceed the present value of future dividends, the stock is considered undervalued. Conversely, if the opposite scenario occurs, the stock is deemed overpriced.
Calculation of Intrinsic Value Using DDM Share Price FormulaThe intrinsic value (IV) can be computed using the following formula:IV=EDPS(r-g) + current value of the expected selling price of the stock
Here, EDPS stands for the anticipated dividend per share, R represents the expense associated with equity capital, and G is indicative of the rate of growth in dividends.
- Discounted Cash Flow
Discounted Cash Flow (DCF) is a technique for determining intrinsic value that considers the forthcoming cash flow produced by the company. The formula for discounted cash flow is expressed as follows: DCF = CF1(1+r)1 + CF2(1+r)2 + … + CFn(1+r)n + the terminal value of the business, where CF represents cash flow and r signifies the discount rate.
- The Relation Valuation Method
The relative valuation method involves comparing the stock price in relation to the company's fundamentals, including revenue, net income, profit, PR ratio, and the book value of equity shares, as compared to its industry peers. If the stock's PE ratio is less than the industry average PE, it indicates that the stock is priced more affordably.
Deciding the share price involves considering factors beyond the stock's intrinsic value. During trading, sellers propose a selling price, and buyers offer their purchase price; a transaction occurs only upon mutual agreement, leading to a rise in share price if the buyer's offer exceeds the seller's.
- The industry's Attractiveness
The industry's attractiveness influences buyers, who are willing to pay more for stocks they anticipate will yield greater returns. They particularly favour companies showing growth potential. This decision depends on factors such as the entry of new competitors, the anticipated future growth, and the company's control over product value determination.
- Performance
Investors are inclined to invest in companies exhibiting strong performance. A company that demonstrates growth, delivers favourable returns on investment, possesses a sustainable business model, effective management, and maintains healthy liquidity will likely see a positive impact on its stock price.
- Management
The influence of management plays a significant role in shaping investors' attitudes. The leadership and profile of a company's management directly impact its stock price. Any statements or communication from the management can swiftly influence the immediate trajectory of the stock price.
- Significant shifts in Business, Management and Policies
Significant changes in business operations, management, and policies can lead to fluctuations in stock prices. The value of stocks may rise if there are positive perceptions about management changes, indicating potential benefits. Likewise, modifications in government policies and regulations can impact stock prices by influencing the company's business model. For instance, an announcement of increased foreign investment in a particular sector by the government might result in a rise in the company's share price.
- Liquidity
Liquidity reflects the market demand for a stock. Higher liquidity makes selling easier for sellers, influencing stock prices as more buyers are willing to engage in transactions when there is a robust presence of both buyers and sellers.
- Monopoly Power
Companies holding a competitive edge over their peers tend to have higher stock prices. In industries approaching a monopoly, a company is protected from competition, allowing enhanced control over product pricing and customer relations. This unique market position leads to significant profits, subsequently boosting the stock price. Hence, companies with monopolies or significant market shares often experience an increase in their stock prices.
Earnings Per Share (EPS) is a crucial financial metric that plays a significant role in determining a company's share price. EPS is calculated by dividing a company's net earnings by its outstanding shares, representing the portion of profits attributable to each outstanding share. Investors often rely on EPS to assess a company's profitability on a per-share basis, providing insights into its financial health and performance.
EPS serves as a key factor influencing investors' decisions. A higher EPS generally indicates stronger earnings relative to the number of outstanding shares, which can attract investors seeking profitable opportunities. Companies with consistent or growing EPS are perceived as financially sound and are often favoured by investors, contributing to an increase in share prices.
Conclusion
The determination of share prices is a complex process that encapsulates various factors, each playing a distinctive role in shaping the value assigned to a company's stock. Investor perceptions and market sentiment, influenced by factors like industry attractiveness and a company's business model, contribute to the dynamic nature of share prices. Investors, dealing with the complexities of calculating share prices, must have a comprehensive understanding of both quantitative analysis and qualitative factors.
