When a company first lists its stock through an initial public offering (IPO), an investment bank evaluates the company's current and projected performance and health to determine the value of the IPO for the business.
The bank can do this by comparing the company with the IPO of another similar companyor by calculating the net present value of the firm. This valuation is often the most important determining factor in deciding the initial share price when larger companies, particularly known private companies, go public.
The company and the investment bank meet with investors through a series of roadshows to help determine the best IPO price. Finally, after the valuation and roadshows, the firm must meet with the exchange on which it will be listed, and they determine if the IPO price is fair.
Key Takeaways
- Share prices are set based on a variety of factors, including a company's projected performance and its present value.
- For larger well-known private companies that make an IPO, the valuation is the most important factor.
- Market news, rules of supply and demand, and herd instinct can also affect initial share prices.
Understanding How Share Prices Are Set
Supply and Demand
Once trading starts, share prices are largely determined by the forces of supply and demand. A company that demonstrates long-term earnings potential may attract more buyers, thereby enjoying an increase in share prices.
A company with a poor outlook, on the other hand, may attract more sellers than buyers, which can result in lower prices. In general, prices rise during periods of increased demand,when there are more buyers than sellers. Prices fall during periods of increased supply,when there are more sellers than buyers.
A continuous rise in priceis known as an uptrend, and a continuous drop in prices iscalled a downtrend. Sustained uptrends form a bullmarket and sustained downtrends are called bearmarkets.
Market News
Other factors can affect prices and cause sudden or temporary changes in price. Some examples includeearnings reports, political events, material company events, and economic news.
Not all types of news or economic reports affect all securities. For example, the stocks of companies engaged in the gas and oil industry may react to the weekly petroleum status report from the U.S. Energy Information Administration (EIA report), but they may not react as strongly to a weak monthly jobs report.
Herd Instinct
Stock prices can also be driven by what is known as herd instinct, which is the tendency for people to mimic the actions of a larger group. For example, as more and more people buy a stock, pushing the price higher and higher, other people will jump on board, assuming that all the other investors must be correct (or that they know something not everyone else knows).
In a herd mentality situation, there may be no fundamental or technical support for the price increase, yet investors continue to buy because others are doing so and they are afraid of missing out. This is one of many phenomena studied under the umbrella of behavioral finance.
