How Is a Stock Price Determined?

How much does a share of stock cost? That’s like asking how many leaves are on a tree. The answer is: it depends.

Once a stock moves out of the initial public offering (IPO) and into the open market, there are several factors that go into setting the price. Sometimes events seem to come out of nowhere – perhaps a terrorist attack, a war, a natural disaster, or recession could all reek havoc on the stock market. If there is anything the stock market can’t stand, it is uncertainty. In the bear market, after September 11th, no one knew when the recession would end, whether we would win the war on terrorism, and whether the US was going to war. Any one of these events could send the market lower as investors seek protection in cash, gold, or real estate. As an investor or trader, it is wise to be aware of outside events.

What Makes the Stock Market Go Up or Down?

The Federal Reserve System

The Federal Reserve System, also known as the Fed, is so powerful that anything it does influences the stock market. The Fed has many responsibilities, including monitoring the economy for problems (most importantly inflation and deflation) and controlling the country’s money supply. With the ability to raise and lower interest rates, the Fed directly affects the stock and bond markets.

The Dollar

When the American dollar is strong against other currencies, like the yen or the Euro, foreign investors will buy our Treasuries and invest in our market. That’s the good news. The bad new is that a strong dollar makes our goods undesirable to foreigners because they are so costly. Conversely, when the dollar is falling and is weak against other currencies, foreigners begin pulling their money out of our stock market. As the dollar falls, the market tends to go down in price.

Inflation

Inflation refers to how much the price of goods and services you buy increase each year. It is usually written as a percentage. For example, assume inflation is currently at 1 percent. That means it will cost you 1 percent more than the year before for the things you buy. When you go shopping, you find that food, medical expenses, home appliances, and fuel have gone up in price. Because of inflation, a new home in 1960 cost you $16,500, it now costs around $300,000, and the price of a seat at the movies cost you 25 cents in 1960 now costs you $10.00. That’s inflation! Too much inflation is not good for the economy. It means that people are getting less for their dollar. On the other hand, low inflation is good for consumers because they can afford to borrow, charge purchases on credit cards, and buy homes. The more consumers spend, the better the economy is.

Deflation

The opposite of inflation, deflation means that the supply of money and credit is being reduced. It may seem like a good thing, but when the prices of nearly everything falls and supply piles up, manufactures are forced to cut prices even further to entice shoppers to spend. They may have to lay off employees, leaving families short on cash. Real estate prices fall and the stock market goes down. Prices are low, but few people have money to buy anything. Those who do have money wait for prices to drop even further.

Politics

The actions of the President and Congress influence the stock market. From a major presidential speech, to higher taxes, or a new law, how the market reacts depends on how Wall Street interprets the news. After all, the market is partially based more on perception and psychology than reality.

Other Reasons

The most apparent reason that a stock goes up or down is how much money the corporation makes. If a company is making money or might make money in the future, more people want to get a part of that action and will buy shares of its stock.

It’s a game of supply and demand. Because of supply and demand, when there are more buyers than sellers, the price of stock will go up. If there are more sellers than buyers, the price of the stock will go down. This is Capitalism 101.

Frequently, stocks go up or down based solely on peoples perception. This is often why corporations spend so much money on advertising and on actions that will bring them positive publicity. You will often find shareholders sending out emails to strangers or posting messages in internet chat rooms to try and boost the popularity of a certain stock, in hopes of people buying it.

The mood of the country and state of the economy also affect why stocks go up or down. Yet again, so much is based on perception. If people believe that the country is on the right track and the economic conditions are good, they feel safer and more inclined to invest money in the market.

What Affects a Stock's Opening Price?

If the company Top Palms which deals in palm oil closes on Wednesday at 12.5, what will it open at on Thursday morning? The answer is: Who knows? Most likely, it will open somewhere around 12.5, but any number of things might cause it to open higher or lower. Before the market opens on Thursday:

• Civil war in Malaysia, one of the prime producers of palm oil
• President of Top Palms arrested for looting the company
• FDA says palm oil cure baldness
• Huge oil reserves discovered on Top Palms property

All of these circumstances and several others could cause the price to go up or down. But in the end, the question of what the buyer is willing to pay and what the seller willing to accept determines the price of the stock. A stock may be a good buy at $25 a share and a terrible buy at $60 a share to one investor, but another investor may not think twice about paying $60 per share. Which is the right price? Sometimes only time will tell. Some time ago, some investors thought $10 a share was too much for Microsoft and refused to buy it. Too bad for them.

Each day the market opens, it’s a clean slate. There are no set prices for investors to meet. Stocks that were flying high the day before may not get off the ground today. The ugly duckling becomes a cash cow (how’s that for mixing metaphors). In the end, do what’s right for you and invest what you feel comfortable investing.