This is the third article in our guide to stocks. In this article, we show you what goes into a stock’s price, and why prices can change so dramatically. For the second article, which discussed how stock trading works, click here.
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Introduction
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The wild and seemingly random fluctuations in the market may make you think that a stock’s price is nothing more than a lottery number, but you’d be surprised at just how much goes into determining a stock’s price at any given point.
A stock’s price has to start somewhere, and that somewhere lies in the IPO process that we told you about back in part 1. Do you remember how we said that when a company wants to sell shares of itself to the public, it usually hires an investment bank to do the dirty work? Well, part of that dirty work is determining what a stock’s initial price should be. This, in itself, is a difficult process.
Initial due diligence and research
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Consider the fact that, in an IPO, the investment bank will buy all of the newly issued shares in a company, and will then re-sell those shares to the public. In doing so, the bank has to make sure that it prices the shares low enough that it can find buyers on the first day, but not so low that it loses money in the transaction. In order to find just the right price for this new company’s stock, the bank goes through a long period of due diligence.
It meticulously pours through the company’s records to see what its sales figures look like, how much money it’s making, what the growth figures look like, who the customers are, what the expenses are, and a variety of other factors that can let the bank predict the company’s future performance. Once it has all of this information, the bank can create a model to determine the market value of the company – or what it will be worth once its shares are sold.
There are a variety of models used to determine a company’s market value, but most of them will basically take the company’s earnings numbers, predict how fast they’ll grow, discount these future profits back to present day value, and come up with a number that represents the company’s true worth.
Once the bank has done this background work, it contacts potential buyers around the world to have pre-sales meetings, answer questions about the new company, and gauge the level of interest in the company’s newly offered shares.
After it has all this information, the bank combines its estimates about the true value of the company with its knowledge of buyer interest in the new shares (and, at times, contracts that guarantee the sale of shares) to determine the number and price of shares in the new company.
Once it does so, it will create and buy all of these shares from the company in preparation for the IPO. At this point, the company now has a bloated bank account and the bank has millions of shares that it’s ready to sell to the public on day 1.
Public buyers
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With these new shares ready, and the bank already having contracted with one of the major exchanges we told you about in part 2, trading in the new company is good to go. On day 1, the bank will sell its shares to the public. If it did its job well, it will have excited enough buyers to quickly and fervently scoop up shares in the new company, making itself a hefty profit.
But how do buyers know if they’re getting a good deal or not?
Well, a lot of that has to do with buyers’ own analysis and research, as well as any analysis and research that the investment bank has provided. When a company first goes public, there’s not a lot of information for analysts to go on – they can check sales figures, growth prospects, customer base – essentially the same things that the bank had to check when first coming up with a price. With this information, buyers can create their own model of a company and can determine if it is currently a good buy.
At the beginning, it can be difficult to tell whether a new company’s shares are a good purchase or not. No one really knows where the stock is going to go, so buying at the start can be risky. That’s why many investors tend to wait until a company has traded for some time before they decide to get in. After a bit of history, investors will have more information and can improve their estimates for the company’s future performance.
So how will they use this information to influence stock prices? Go to the next page to find out.
