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Who Sets a Stock's Price?

May 21, 2008
There are many, many factors that affect the price of a share but basically it is determined by how much somebody is willing to pay for it.

Perceived Value
Just like any other auction, the price is determined by the perceived value of the item being traded. It cannot be calculated or determined by a formula. A good example is that house prices fluctuate on a daily basis even though the actual houses are not physically changing.

Biggest Factor - Earnings
Probably the biggest factor in determining the price is the company's earnings (profits), both now and future projected earnings. Each quarter, every publicly-traded company is supposed to publish its projected earnings per share for that quarter. At the same time, market analysts publish their predictions for many of those companies. If the company falls short of their own projections or the analysts' predictions, the price will often fall five percent or more. That is because the price before the actual earnings announcement was made was based on estimates that turned out to be inaccurate. On the other hand, if a company announces projections of much larger earnings than investors were expecting, the price would probably go up because the future perceived value would then be higher.

Intra-Day Factors
Many stock prices fluctuate one to five percent throughout a trading day. Is this because the company's real value is changing that much throughout the day? Probably not. These fluctuations are mainly due to factors outside the company, including:
- What the market is doing today (up, down, etc.)
- Other stocks in the same industry
- World news, such as oil prices and terrorist attacks
- Day traders trading large quantities of shares and affecting the price
Although these factors may not be related to the actual company, they have a very real impact on the price.

Long-Term Factors
The biggest long-term factors have to do with the company's actual financial performance. Therefore, the long-term price should reflect what the company is actually worth. Here is a partial list of these factors:
- Earning now
- Earnings for future quarters
- Prospects for new business
- Amount of debt
- Competitors

The Price is Wrong
It is quite common for a stock price to be significantly higher or lower than it is really worth. This can be due to external factors, such as what the overall market or economy is doing, or it could be a temporary overreaction by investors due to rumors about the company, whether they are true or not. In these cases, it could be said that the price is "wrong," and that creates an excellent trading opportunity.

A great example of overreaction would be like when Apple announces a great new gadget and thousands of investors go load up on APPL shares. This creates a supply and demand issue where there is not enough supply to meet the demand of the buyers, so naturally the price will go higher and higher. The actual value of the company should actually increase because their sales will go up thanks to this new gadget, but the share prices may temporarily exceed the actual value of the company due to this buying frenzy. Again, that can create a great trading opportunity.
About the Author
Nicholas Swezey is the creator of the Stock Market Simulation at HowTheMarketWorks.com.
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