Today I will try to answer a question which I received from one of our subscribers. Vijay asked –

“How are stock prices determined? I mean, why would a stock like Bosch trade at Rs. 26000+ while Noida Toll Bridge would trade at Rs. 35? Does it purely depend on how many shares are ‘in circulation?”

Yes, it is mostly about the number of shares in circulation. For the academically minded, I will detail this in some length in the second point to this article (below).

Theoretical Explanation: Face Value vs. Trading Price of a Share

Sometimes people get so confused with stock market and stock prices and the constant talk about financial products that they forget that there is a real business behind these stock prices and these complex products.This in no way changes the fact that all what a stock price tells you is the price of a business. Each business has a value which is reflected in the price of its share.

Face Value: Let’s say Company A has issued 1,000 shares @ Rs. 10 a share. The price you need to pay to buy the whole of Company A is Rs. 10,000 (1000*10). If the Company reduces the face value of its share to Rs. 5, naturally the number of shares in circulation will increase from 1,000 to 2,000. This will in no way change the price of the business which will remain Rs. 10,000 (i.e. 2,000 * 5).

Trading Price: Once a company lists on an exchange, its share price or the price at which its shares trade is determined by the demand and supply of the share. If more and more people want to buy the share, the price of the share keeps going up until it finds equilibrium (click to read). If people start selling the share, the price falls.

The trading price of the share rises as the business of the company matures and it becomes profitable. The face value does not change unless the company decides to change it. The company can manage the face value of its share by splitting or increasing it at any point of time.

When company changes the face value, it has a similar effect on the trading price because the number of shares in circulation changes. So if a share with a face value of Rs. 10 is trading at Rs. 1400, the company can reduce the face value to Rs. 5 which will reduce the trading price to Rs. 700. The effect is similar when a company issues rights or bonus shares or when it does a buyback of shares i.e. the trading price adjusts based on the number of shares in circulation.

Again, the trading price of a share is a reflection of the total price of the company’s business. Price of the business does not change based on how many divisions you make of the share.

Practical Explanation: What really happens in the market with listed shares?

In reality, what investors pay for when they buy shares in a company are the future returns which a company will make. Calculating future returns is always subjective based on the company’s current business and its future plans. While overall economic and industry situation will play a big part in determining the share price in the short term over a longer period it is really the future returns which the business makes that you are paying for.

How Much Will a Business Make in Future?

Maximum stock market research is focused on how much money a business is likely to make in future. There are 2 main methods in which this is estimated – the price earnings method and the cash flow method. I will briefly touch on these 2 without deviating too far away from our present discussion on what really determines the price of a stock.

1. Price Earnings and Future Price Earnings Multiple – You can see a detailed post on this here.
2. Cash Flow Method – This is a very popular method especially for companies that do not rely on much debt. The easiest way to understand this is by thinking of the entire Company as your private business. Would you pay Rs. 10,000 to start the business of Company A?

Let’s say Company A plans to make a machine which will manufacture jute bags. The investment in business for the first year is set at Rs. 18,000 and from the 2nd year onwards you expect to start making the following returns from the business:

 Expected Future Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 Total NIL 4,000 8,000 12,000 12,000 36,000

In other words, in 5 years the total investment in the business will be Rs. 18,000. During the same period, the total (net) return from business will be Rs. 36,000.

Now calculate the present value of this expected FCF of Rs. 36,000. An easy way to do this is to ‘calculate the present value for each year’s expected FCF’ and add them up. Use the formula below to do this.

Present Value = FCF / (1+R) n

Where:

R= Discount Rate

What is discount rate?

It is the minimum rate of return which the investor expects from the investment. Think of it as the rate which a bank fixed deposit yields. I will assume this to be 8.5% in my example which is the current FD rate.

Remember – the right discount rate is what an investor is able to get from another investment which carries a similar degree of risk. So for example if an investor is getting a return of 14% risk-free from any other investment (for whatever reason) he should take 14% as the discount rate.

N = Number of Years

WHAT WE ARE REALLY DOING IS TRYING TO CALCULATE HOW MUCH THE FUTURE CASH FLOWS IN THE TABLE ABOVE ARE WORTH TODAY?

 Present Value of Expected Future Cash Flows (using the above formula) Year 1 Year 2 Year 3 Year 4 Year 5 Total NIL 3,397.82 6,263.26 8,658.89 7,980.55 26,300.52

What does the math above mean?

It means that you will be paying Rs. 18,000 today and in return what you are getting is Rs. 26,300.53, today! – i.e. the present value of what your 18,000 will generate over 5 years.

Once you know how much your money could earn in future by investing in Company A, you can decide if it makes sense to buy Company A or invest elsewhere.

When you buy a few shares of Company A, it is no different. In this case, you will be a fractional owner and hence you will divide the total future cash flow of the company with your percentage shareholding to check your share of future cash flows.

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Coming back to the question – how are stock prices determined ?

Besides how the company decides to split its equity, there are 2 other factors which play a part in the determination of a stock’s price.

Factor No 1: Forecasting of Future Returns and hence the Share Price

In the markets, everybody views things differently and forms an opinion about future based on present facts. In the example above, each analyst will come to a different conclusion about future cash flows and about how much he should be paying for a business today.

Based on what different analysts and investors feel about a company, they value its shares differently. At the end of the day – a thing is only worth what someone would pay for it.

Since future is uncertain it creates an opportunity for all sorts of predictions and opinions. Further, there is constant news flow both from the company’s side and at the wider macro level. All this creates different growth trajectories for the company and hence people want to pay different prices for the same stock. in fact, the same people want to pay different prices at different times. The result – constantly changing price of the company’s stock. Careers are made and end doing this exercise and markets move on.

To understand how buying and selling happens practically on a trading terminal, do read this – Equilibrium Price.

Factor No 2: Manipulation

Of course the markets are not run by the most ethically or morally pure people. There are operators, corrupt promoters, insiders, news breakers and so on. There are those who indulge in unscrupulous buying and selling. I cannot finish this post without repeating this –

If for absolutely no reason, a few of us got together and started buying a large number of shares in a loss making company, the share price of such company will indeed rise dramatically. Sometimes this is not fair! It happens on a daily basis in the market.