How Is Share Price Determined?

How Is Share Price Determined?

A company's market capitalization is first established in an event called Initial Public Offering (IPO). During this process, the company usually pays to an investment bank to use different valuation techniques to derive the company's value. They also determine how many shares will be offered to the public and at what price.

What is Market Capitalization?

Market Capitalization which is also referred to as Market Cap is nothing but the product of the company's share price and the number of shares.

Market Capitalization = Share price x Number of outstanding shares 

How is the IPO Price Determined?

The shares of an IPO are first issued in the primary market.

The most common methods used are as follows:

1. Absolute Valuation Method

2. Relative Valuation Method

1. Absolute Valuation Method:

    

In this method, the value of the asset is derived only based on the characteristics of that asset. There is no consideration regarding the value of other comparable assets that are trading in the market place. These methods are basically known as Discounted Cash Flow methods (DCF methods). 

2. Relative Valuation Method:

Relative Valuation Method is different from DCF method as it doesn't value a firm or an asset based on its intrinsic value. The approach followed in this method is to find a benchmark valuation. It determines the share price by comparing the financial health of the company to similar companies in the sector. There are many variations to this method, we can use price to earnings ratio, price to book value ratio or any number of ratios.

What happens after a company goes public?

This is also known as the Secondary Market.

Once the company gets listed, its share price is determined by simple Supply and Demand Theory. That means if there is a high demand and less supply then the share price will increase (Buyers are more than Sellers) and if the supply is more and demand is less then the share price will decrease (Sellers are more than Buyers).

Factors Affecting Share Price

Besides the supply and demand, the price of a share can be influenced by other factors as well. These include:

1. Financial Health

2. Company, Industry and Economy News

1. Financial Health

Stocks that perform well usually have solid earnings and strong financial statements. Investors use these financial statements and share price to see whether the company is financially healthy or not.

2. Company, Industry and Economy News

Any good news about a company or the sector in which the company works will have a positive impact on the share price, be it earnings report, new product launch or Govt. policies like imposing anti-dumping duties. Similarly, bad news will have a negative impact on the share price.

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