Investors buy common shares mainly because they expect the share price to increase. Over an extended period, what causes share prices to rise is the companies’ increased earning power and ability to pay higher dividends out of these increasing earnings. However, many other factors also impact share prices.
Prices of equity shares move continuously during trading hours. Investors would differ as their valuations of share prices are based on different time horizons, different economic outlooks, and different vested interests.
Information that Affects Share Price
Share prices may change due to information becoming available to investors about various factors, including:
- The earnings prospects and asset values of companies.
- The membership of the company board.
- Adverse factors affect companies, such as legal action against them or action by a bank to call in loans.
- Industry and economy survey, for example, about retail sales or productivity levels.
- Macroeconomic developments, for example, the expected level of interest rates or where an economy appears to be on the downturn of the business cycle.
- Changes in government policy, for example, fiscal and monetary policy.
- Movements in other stock markets around the world, such as the US, Europe, Hong Kong, China, and Japan
- Geopolitical developments include wars and threats from terrorist groups.
Share Prices Follow a Random Walk
Some researchers have examined that the share price movement for quoted companies tends to follow a random pattern, i.e., the trend on any day is uncorrelated to the direction in the previous day. Those who believe in the arbitrary walk notion consider that future share price movements could not be predicted from details of historical trends.
Several other studies show that there is, in fact, clustering in stock returns with sharp movements in prices, either up or down, tending to cluster in a fashion that is inconsistent with the notion of a random walk.
Other studies have suggested that there are cyclical and seasonal patterns in stock price movements, which again are inconsistent with the random walk hypothesis and could provide a basis for some degree of predictability in future stock returns. It is a lively area of debate among investors and traders.
Share Prices Discount New Information
Share prices are observed to move when new information is received and will fairly reflect that further. Professor Eugene Fama, an American economist, developed the Efficient Market Hypothesis (EMH). EMH theory states that financial markets are informationally efficient. Therefore, a market would be efficient concerning an information set if the price fully reflects that information set. The price would be unaffected by revealing the information set to all market participants.
The EMH suggests that market participants have discounted all information and that current prices are, in a theoretical sense, the correct prices. But there are several critics of this theory, including some of the world’s most successful speculators and investors, such as George Soros.
Key Factors that Affect Stock Prices
Interest Rates
Interest rates play a significant role in the economy, and changes in interest rates often affect stock prices. If a company borrows money to expand and improve its business, a change in interest rates will affect how much interest the company has to pay on its debt. The higher the debt, the more the interest rate change can affect that company. High-interest costs can reduce company profits and the dividends paid to shareholders. All of these things affect the price of the company’s stock.
Economic Outlook
As investors look ahead, they will have to consider the economic outlook. If it seems like the economy will expand, this may lead to increased profits and a higher stock price. So, if the economic outlook is positive, this can lead to higher stock prices as investors buy stocks, thinking future profits and stock prices will rise.
Inflation
Inflation means higher consumer prices, and rising prices can lead to some uncertainty in the stock market. Generally, if prices in the economy increase, this often slows sales and reduces profits. In addition, higher prices will often lead to higher interest rates. These higher rates and prices will tend to bring down stock prices. However, commodities, industries, and companies can do better as prices rise, and the stock price of companies dealing in commodities may increase. In general, higher prices and interest rates tend to reduce stock prices.
Economic Shocks
Significant changes in the world can affect the economy and, therefore, stock prices. For instance, there may be a sharp rise in energy costs. That can involve a lot of companies and consumers and lead to lower sales, profits, and stock prices. Another example is an act of terrorism, which can lead to a downturn in economic activity and a fall in stock prices.
Changes in Government
When a different political party is elected to form the government, it can have different views and make policies separate from the last government. Sometimes they can be seen as good for business. Sometimes they can be seen as bad for business. Sometimes they can be seen as likely leading to higher inflation and interest rates – or lower inflation and interest rates. For this reason, changes in governments can lead to changes in stock prices, as investors try to figure out if the change will be good or bad for companies and investors.
Currency Exchange Rate
Many companies sell products to buyers in other countries. Such companies set prices in $ or Euro, Canadian dollars. If the value of the Indian rupee rises, buyers from other countries will have to spend more of their currency to buy Indian goods. It has the same effect as when the price of a product goes up. This can sometimes lead to lower sales, leading to a decline in the price of some export-oriented companies – especially for those companies that sell much of their product to other countries. On the other hand, when the currency price falls, export is cheaper, increasing the price of stocks.
Although several giant corporations have decided to remain private or unlisted companies, it is common for companies to want to seek a listing on a stock exchange once they reach a specific size and have plans to expand their business. They will then engage an investment bank to act as an underwriter and issuer of an initial public offering (IPO) in which new shares are issued by the company and sold to new subscribers to the offering, i.e., new shareholders.
Listing of Shares
Shares must limit a company if it wants to offer shares to the public via an IPO. Some of the reasons that motivate an investor to purchase shares are:-
- To receive income through the receipt of dividends which companies pay out from their net earnings.
- To gain from increases in the share price in the form of capital gains. While this will be a primary motivation for many individuals, there is no assurance that shares purchased at one time and sold later will have gained in value.
Conclusion: Use of Share Price in Investment Decision Making
Initially, share prices are determined through a company’s Initial Public Offering, in which the price of one share is set according to the perceived supply and demand for that company’s stock. The prices are usually placed by a book-runner – a lead manager appointed to help the company determine a fair price for its IPO. After the IPO, a company’s share price can be impacted by factors like performance, macro-economic factors, demand and supply of company shares, etc.
All the above help an investor decide about purchasing and selling shares in different companies.
Prices of equities move continually during trading hours. Investors would differ as their valuations of security prices are based on different time horizons, different economic outlooks, and different vested interests.
For markets to work correctly, disagreements, different time horizons among the participants, and different agendas and priorities must function correctly. While some traders think that an asset is worth buying at a specified price, there would be others who, for various reasons, believe that it is worth selling at that same price.
