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How is the Share Price Calculated?

  • Apr 30, 2024

Understanding how share prices are determined is a crucial aspect for investors getting through the vast world of the stock market industry.So, let us get a brief idea of the intricate processes that contribute to the calculation of share prices, shedding light on the factors that drive these valuations.

Intrinsic Value: The Foundation of Share Pricing

To ascertain or know if a stock is underpriced or overpriced, investors often turn to intrinsic value. This fundamental concept plays a pivotal part in the decision-making process, helping investors gauge the fair price of a stock.

However, three popular indicators to find out intrinsic value include the Relative Valuation Method, the Dividend Discount Model (DDM), and  Discounted Cash Flow (DCF).

- DDM calculates intrinsic value based on expected dividends, considering factors such as the price of equity capital and the growth rate of dividends.

- DCF, on the other hand, assesses an inherent worth by accounting for the organization's projected potential cash flow.

- The Relative Valuation Method compares a stock's price with key fundamentals and industry averages.

Market Dynamics: The Price Discovery Mechanism

Market dynamics unfold through a vast and ongoing process known as the price discovery mechanism, intricately shaping the actual share market price. This intricate system relies on the interactive forces of buyers and sellers engaged in the market.

At its core, the price discovery mechanism is a continuous and fluid process where market participants, driven by varying motivations and expectations, engage in transactions. The essence of this mechanism lies in exchanges actively calculating real-time stock prices, seeking the equilibrium point where the maximum volume of shares is exchanged.

Crucial to this process is the bid and ask prices, representing the intentions of buyers and sellers, respectively. The bid price signifies the maximum amount a buyer is willing to pay for a stock, while the asking price represents the minimum amount a seller is willing to accept. The convergence of these bid and ask prices determines the prevailing market price at any given moment.

Additionally, as these bid and ask values fluctuate based on the ever-shifting supply and demand dynamics, the market price undergoes continuous adjustments. The ebb and flow of these values, influenced by myriad factors such as investor sentiment, economic indicators, and company performance, intricately shape the trajectory of market prices.

Key Factors Influencing Share Prices

1. Industry Attractiveness: Buyers are willing to pay higher prices for stocks in industries poised for growth. Factors such as new competition, future growth prospects, and a company's authority in determining product value influence industry attractiveness.

2. Company Performance: Investors favor companies demonstrating growth, better investment returns, a better business model, strong management, and solid liquidity. A company's performance directly impacts its share value or price.

3. Management Influence: The management's profile and performance significantly sway investor sentiments. Announcements or commentary from management can trigger immediate effects on stock prices.

4. Changes in Management, Policy, and Business: Significant changes in management or government policies can lead to fluctuations in stock prices. Positive changes often result in increased stock prices.Liquidity: The amount or stock quantity in demand affects liquidity, influencing both buyers and sellers. Highly liquid stocks are generally easier to sell, impacting stock prices.

5. Power of Monopoly: Companies with a competitive advantage or near-monopoly status can command higher share prices due to improved management of product costs and customer interactions.

Factors Affecting Multiple Stocks

Various external factors can impact entire sectors or the entire economy, including interest rates, economic policy, industry, market sentiment, inflation and deflation trends, global fluctuations, and natural disasters.

PE Ratio: A Key Metric for Investors

The Price-to-Earnings (PE) ratio stands out as a pivotal metric for investors, offering valuable insights into a company's financial health and market valuation. This crucial ratio is derived by splitting the market price of a stock by its earnings per share (EPS). Investors widely recognize the PE ratio as a key indicator of a stock's relative value and potential for growth.

When evaluating the PE ratio, a lower value is generally perceived as advantageous for investors. A lower PE ratio suggests that the market values the company's current earnings more conservatively than its stock market prices today. This could imply a potential undervaluation, making the stock appear more attractive for investment.

On the contrary, a high PE ratio raises a cautionary flag, as it may indicate that the stock is potentially overvalued. A high ratio implies that investors are willing to pay a premium for each unit of earnings, possibly anticipating substantial future growth. However, it also introduces the risk of a downturn if the company fails to meet these optimistic expectations.

Conclusion

The calculation of the current share price involves a complex interplay of intrinsic value, market dynamics, and various influencing factors. Investors keen on navigating the stock market successfully should grasp these intricacies to make informed decisions. A reputable broker, such as Angel One, can provide valuable insights and assistance in understanding and getting through the intricacies of the stock market price process.




Team Sharekhan
by Team Sharekhan

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