If you want to learn how to value a stock well…they aren’t priced like the items at your local grocery store. They are constantly changing, with dramatic results. Imagine going to the store and paying $20 for a loaf of bread that was $2 a week ago. This article will teach you how to value a stock and what goes into the final price point.
The Pyramids, the Bermuda Triangle and Prices: Three Great Mysteries of Life
Pricing can sometimes seem like a bit of a mystery. Sometimes things are way cheaper than you think they “should” be—and sometimes they’re way more expensive. But thanks to the magic of the free market, prices for everything—whether it’s loaves of bread or jet aircraft or even things like home insurance—are set so that sellers are willing to sell, and buyers are willing to buy.
But there’s one thing that even economists sometimes find baffling: how to value a stock.
How do you value a stock? After all, there are no physical inputs. There’s no package design. There’s no marketing, or advertising, or displaying the stock on shelves. In fact, a stock is…well…it’s not even a THING!
In a free-market economy, price is set by the market without any intervention by the government. And the way the market sets the price is by matching supply and demand.
Let’s look at that a bit more closely.
Supply and Demand: the Twin Forces of the Market
Imagine a farmer. He plants his wheat in the spring and sells it in the fall. His customer is the bread company.
When the bread company shows up at the farm, the farmer states his asking price; and if the bread company agrees to it, it will cut him a cheque, take the wheat and bring it back to the bakery.
But what happens if they don’t agree? What happens if the bread company says, “Hold on, Farmer Joe—$5.22 a bushel?? Are you crazy??
Anyway, if Farmer Jeb really is asking $4.91, Farmer Joe really does have to match the price.
But if the bread company is just bluffing, and Farmer Jeb is also asking $5.22 a bushel, Farmer Joe has the upper hand. He’ll say: “You don’t scare me, Bread Man. I know Jeb and he’s asking $5.22.”
Market Equilibrium: How We All Get Along
That, in a nutshell, is how the market works. Suppliers ask a price. Buyers offer a price. If they agree, a sale is made. If they don’t, the buyer has to offer more or the seller has to ask less—until they reach a point where they’re asking and offering the same price.
And it’s like that all along the supply chain: from farmer, to bread maker, to supermarket, to consumer. And for every good and service. When buyers and sellers agree on a price, the market reaches what is called market equilibrium. The price is stable, and everyone gets along….
Stock Prices and Market Cap
Now obviously a lot of things can happen to disrupt market equilibrium. Let’s say there’s a drought and farmers have only half the wheat to sell that they had last year. Bread makers will be scrambling to find enough wheat for their bakeries. They’ll offer higher prices—and farmers will willingly accept them. The market equilibrium price of wheat (and ultimately of bread) will go up.
And of course the reverse can also happen. If the farmers have such a fantastic crop they can’t find enough bread companies to buy all their wheat, they’ll ask for lower prices—and bread companies will willingly accept them. The price will go down.
OK, that’s bread. What about stocks?
This basic rule of the market—the price is determined when buyers and sellers agree—applies to everything: clothes, food, housing, life insurance, whatever.
But does it apply to stocks?
In a word, yes. It’s true that stocks are different from just about everything else in the market. You can’t wear them, eat them, drive them or make them pay for repairing a flooded basement (the way home insurance does). But the price of a stock is determined by buyers and sellers agreeing in the market.
Prices determine market cap
The price of a stock is really important. For one thing, it lets you calculate a company’s market cap. Market cap is short for “market capitalization,” and it tells you how much the market thinks a company is worth. To figure it out, all you do is multiply the price of one share by the number of shares outstanding, like this:
P (share price) x N (number of shares outstanding) = Market Cap
For more information, check out this video.
Of course, it’s a great thing to know how much a company is worth. But if you’re like most people, you still have a nagging question: how do buyers and sellers decide what they think a share (and by extension, the whole company) is worth?
Yeah, figuring out what a stock price should be is a nagging question for just about everyone—including investment experts. And a big part of the reason is that when you buy a stock, you’re not just putting a value on the company today. You’re estimating the value of it tomorrow—and maybe 10, 20 or 30 years from now.
Make money by learning how to value a stock
You own stocks to make money—now and in the future.
There are a couple different ways in which stocks do that. One is capital appreciation—the stock goes up in price. Another is dividends—the stock pays you cash on a regular basis. But given that not all stocks appreciate, and not all stocks pay dividends, that raises a big question: how do you know how much money a stock will make you?
Yup, that’s the million (or billion) dollar question in investing. Because you need to know how much a stock will make you in order to decide how much you should pay for it. And while we won’t go into ALL the different factors that go into that decision, we’ll touch on one of the most important: earnings per share.
Earnings per share (or EPS) is just what it says: the amount of money the company earned in a year, divided by the number of shares outstanding. Finding that figure is easy: in a company’s annual report—or your newspaper’s financial pages—you can find it under “EPS.” (Convenient, huh?)
And understanding it is almost as easy. When it comes to earnings, more are better than fewer. Earnings that grow from year to year, rather than decline—that’s better too. And earnings that are predictable, rather than yo-yoing up and down every year—that’s also a good sign.
Value and Stocks: Comparing Earnings to Price
And that brings us to how investors decide what a company (and therefore a single share) is worth. They look at a whole bunch of things—the quality of management, the company’s finances, the prospects for growth—but arguably the most important is earnings. Are they high? Have they been growing steadily? Is it likely they’ll keep growing?
If the answers to those questions are all positive, investors will then compare those earnings to the price of a share using another important number: the P/E ratio.
The P/E ratio is the share price divided by earnings per share. Say a company’s share is $50. And say that each share earned $5.00 last year (that’s the EPS). Then the P/E ratio is $50/$5 = 10.
This is also a very easy ratio to find—on any financial website listing stocks it will show P/E. That’s what you’re looking for!
Still not convinced? Watch this video to find out more about P/E ratios.
Investors use P/E ratio as the best guide to determining whether or not a share is cheap or expensive. (There’s a lot of debate about whether it is the best guide—but there’s no debate that it’s the one that’s most commonly used.) In simple terms, it answers this question: how much are you willing to pay for the future earnings of this company?
This is a VERY complicated topic, so we’ll examine it in greater depth in other WSS courses. But here’s what you need to know for now: comparing P/E ratios between companies in the same industry is good way to compare their stocks. It’s only the beginning of the stock-picking process, but it’s the starting point for you as an investor.
Investor Behavior’s effects on the Value of a Stock
OK, trying to explain a stock price in one lesson is like trying to explain the entire plot of Game of Thrones in 60 seconds. There’s just too much to digest in one sitting.
But we do want to introduce you to one aspect of stock pricing that you should know about now. And that’s something called investor behavior.
Consumers? Predictable. Investors? Not so much.
Consumer behavior is generally pretty predictable. Take dishwashers, for example. While inexplicable crazes sometimes occur, it’s a pretty safe bet that households will only have one dishwasher at a time—and they’ll only get a new one because they need to, not because they’re bored with the one they now have. And that applies to the vast majority of consumer goods.
Investor behavior is quite different, however. It’s really not that predictable. Sometimes—often, in fact—people get really excited about a company or sector. (Remember the tech bubble of the late 1990s?) They go nuts for its stocks. They buy, buy and buy again. And the price shoots through the roof.
And then it sinks like a stone.
There’s no knowing what will cause investors to suddenly get really hot about a company. Or what turns them really cold. Scientists can’t explain it. Nor can psychologists. And certainly not economists. It’s a mystery.
Investor Sentiment—Buyer Beware!
But “investor sentiment,” as it’s called, is really, really important in determining a share price. If a biotech company makes a big breakthrough in stem-cell technology, that’s a good reason for its price to rise: future earnings will likely be bigger than expected. But should the price double? Triple? Go up by 20 times?
In theory the rise in price should be proportional to the likely change in future earnings for the company. But in practice, people can get so excited that they push the price WAY above that level. And then because the price is rising, more investors start piling in. And that pushes the price even higher.
It can go on and on like that. (When that occurs in entire sectors of the market you have what is called a “market bubble”—so named because it’s guaranteed to burst.)
Investor sentiment can be positive or negative. It can have a small effect on share prices, or it can be huge. It can be based on rational factors, like a change in earnings; or it can be based on things that make no sense, like a belief that a stock will keep rising because it has been rising steadily for a year.
However it manifests itself, investor sentiment plays a significant role in determining the price of a stock. And it’s so complex that there’s no sure way of guessing which way it will move next.
Conclusion: How to Value a Stock
The price of a stock is determined the same way the price of anything is determined: by agreement between sellers and buyers. But how do sellers judge what is a good price at which to sell? And how do buyers know what is a good price at which to buy? If there’s one thing you’ve learned from this course, it should be that that is a very complicated process.
As we noted, there are a lot of things that influence investors’ decisions about the value of a company, from the quality of the management to the quality of the competition. Buyers and sellers make judgments about those factors—and probably the most important is the company’s earnings.
Is the market always right?
In theory, there is a correct value for a company. And if a company’s share price is too high—if the company is overvalued—then the market will adjust the price. Sellers will have to lower their asking price, and the market equilibrium price will drop until the company is correctly valued.
That’s in theory.
In practice, a company can be over- or undervalued for a long time. Maybe investors are so excited about the celebrity CEO that they overlook the terrible sales figures month after month. Maybe they’re so discouraged by sales figures that they overlook the dull but brilliant and hardworking CEO. Investors are funny that way.
The purpose of this course is to get you to remember that. Smart investors look at all the factors that go into a price. They invest for the long term. They recognize the importance of earnings, but take into account other things, like the global economy.
And they always remember that there’s something called investor sentiment. It can affect stock prices in a major way—and sometimes create undervalued stocks that are every investor’s dream.