Saturday, October 23, 2010

How the price of a stock is determined?

What determines the price of a share? This question bothered me a lot when I was first introduced to the world of Stock Market investing. Why some shares are trading at single digit prices while some are trading in 4 digits and some even in 5 digits. 

As on 22nd october 2010 the market price of INFOSYS was 3050 and that of TCS was 1050. Both are part of the SENSEX and NIFTY index. Did you ever asked yourself why TCS is trading at 1/3rd of the price of Infosys in-spite of the fact that TCS is around 25% bigger than INFOSYS in terms of absolute revenue and profits. If you ask a layman investor to choose among them, he will definetly go for TCS as its ticket price is far less than that of INFOSYS.  

To an unknown investor a 30 rupee stock looks always cheaper than a 300 rupees stock. But in stock market a 300 rupees stock might be comparatively cheaper than the 30 rupees stock and hence might be a better bet.

To understand more about the market prices of both the stocks let's consider stocks A and B. Let us assume that both the stock are in the same industry and have the same annual revenue and profits. But stock A has equity capital of 1 Crore rupees divided into 1 Million equity share of FV Rs 10/- each while stock B has the equity capital of 4 Crore rupees divided into 4 million equity shares of Face Value Rs.10/- each.

Let's say the revenue for both the company is 100 crores and profit of 10 crores. So the earning per share for the Company A is 10 crores divided by 1 Million shares i.e Rs. 100. Earning per share for Company B is 10 crores divided by 4 million shares i.e Rs 25
If both the companies trade at same earnings multiple say 10, then the stock prices of both the stocks should be as below:

Stock A = 100*10 = 1000
Stock B = 25*10=250

So inspite of the fact that both the companies are equivalent in all aspects but have different capital structure, the price of stock A is 4 times the price of stock B. So for an unknown investor if he takes decision based only on the stock price, he might end up buying stock B because it looks 4 times cheaper than stock A while the fact is that both of them are logically same.

The price of a stock is dependent on following factors:

Equity Capital Structure: As explained above in the example equity capital has direct bearing on the price of the stock. Keeping all other factors constant the stock price is inversly proportional to the outstanding equity shares. That means higher the number of equity shares lower the price.

Growth Outlook: Keeping all other factors constant the price of a stock is directly proportional to the growth expected in the company's earnings. The higher the growth outlook for the company , the higher is the multiple discounted by the invetors and hence higher is the price.

Operational efficiency: The company which generates better return on Capital employed, and has better profitability margins, trades at higher earnings multiple than the company which generates lower return on capital employed and has lower profitability margins.

Other factors: There are lot of other factors which also plays a role in stock price determination, such as the quality of management, shareholding pattern, liquidity of the stock etc. These factors actually determine the earning multiples and subsequently the price. Better managed companies usually trades at higher multiples because of their trusted execution and management capabilities. Low liquidity might sometimes result in higher demand for the stock and hence the prices of such stock might be higher.

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