NSE #9: Unraveling the mystery behind stock prices

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If you're just joining in, I'll recommend you read my previous NSE series posts.

image: trak.in

Today, I'll be explaining how a stock gets it's price. And as we know, we consider our stock purchase a good investment only when we see the stock price going up and not down. So an understanding of what makes a stock's price go up or down is very vital.

As a quick recap.
There are 3 ways to own a company -- you start/inherit one, you buy a company's stock, or you buy a company's bond.
We've got preferred stock and common stock. It's the common stock that is being traded on the stock exchange. Hence, whenever I write stock [with no adjective] I mean common stock.

When a company wants to go public, it's bankers value the company's assets (buildings, equipment, bank account, intangibles, etc) and value it's liabilities (mostly debts). Then, they deduct the liabilities from the assets and name whatever value they get as the company's book value. Then they do some financial modelling magic to calculate the lifetime earnings of the company and then discount it to today's cash. They call that the company's valuation. It's that amount they quote to the public to buy at. They can split it to 100 million units and sell to you & me. That's what's is called an IPO. Initial Public Offer. The good part is that they also give you a free prospectus detailing nearly everything about the company, especially the book value that shows what money the company should really be exchanging for. But these bankers are marketers at heart. They put up fancy billboards. They change our favorite tunes to advertising jingles. They almost brainwash us via radio, TV and internet adverts. And even though we can see the truth in the prospectus, we still believe the future they are painting for us and buy into the IPO.

After the IPO, the other professionals (the ones that make their living reading financial statements) come in. They focus on what we ignored, the financial numbers. They run series of calculations. They make future projections. They compare the company's numbers with that of similar companies. They come up with their own valuation of the company. And God help us if it's less than what the IPO guys gave. The same marketers that lead by example, buying into the stock, will be the first to dump the stock and crash the price to what the stock market professionals think. Then after a while the company's stock price stabilizes.

So what makes a stock's price go up and down?
It's the stock market professionals, the guys who are full-time stock traders. They are like car dealers. Professional car dealers have a near perfect idea of what every car is worth. Whenever they see a car being sold for less than it's worth, they buy it instantly and move the price up to the market price. But their biggest effect lies in the fact that they are constantly scouting for such offers. They make it nearly impossible for you and me to find those cheap car offers. They are constant buying them out and moving the price to what they think, thus, setting the market price.
And that's how the professional stock traders operate. They have this idea of what a stock should be sold at, and force everyone to trade at that price. 

To understand how stock price goes up and down, you will need to understand how the professionals determine a stock's price. It's part science, part greed and part fear. Though you can always get the science part right (which is why I'm here) and be able to predict it's effect on stock prices, you can't always get the greed and fear part right. So in the end, you can't always predict stock prices.

A stock price will go up if the professionals believe it's worth more than it's selling for, and it will go down if they believe it's selling for more than it's worth.

Why did the 2008 stock crash happen?
It was simply because the greed and fear part dominated.


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