Equity markets are known for creating wealth over a longer period of time. Hence it attracts a lot of interest from people looking to invest their saving and generate returns on their investments. So, that brings us to the question - how are stock prices determined?
Economics at play
Stock prices are largely determined by the forces of demand and supply. Demand is the amount of shares that people want to purchase while supply is the amount of shares that people want to sell. The price discovery happens where demand and supply meet at a particular price level (equilibrium) i.e. both the buyer and seller agree to trade at a particular price point. A continuous rise in prices is known as an uptrend, and a continuous drop in prices in called a downtrend. Sustained uptrends form a "bull" market and sustained downtrends are called "bear" markets.
Factors affecting demand supply
Demand and supply of a company is influenced by its underlying business. If the business of the company is doing well, demand for it rises as more investors want to own a part of the company. The increase in demand leads the buyers to bid up the prices of the stock to entice sellers to sell them. As a result the stock price increases. Conversely, if the company isn’t performing well investors want to sell their shares in the company thereby increasing supply.
The increase in supply leads the sellers to bid down the prices hoping to attract buyers to buy the stock thereby reducing the price.Since quality of the business determines the investor demand and supply in the market, it is therefore important for us to understand the factors that impact the fundamentals of a company.
Industry specific factors
Industry growth – This is a key driver for a company. Various situations include –
Technological Innovation - From out-dated business models to new ones. Example – wired telephones to wireless mobiles.
Market penetration – Since housing demand is expected to rise steadily in India over the coming years, building materials is expected to do well.
Regulatory changes – Electric vehicles is expected to do well going forward due to government push towards clean energy.
Attractiveness of industry structure -
Porter’s five forces framework is the ideal way to assess the attractiveness of industry structure.
Inter-firm rivalry - Higher the rivalry among existing companies, lower the industry attractiveness and vice-versa. Example: the Indian Wireless Telecom sector is a huge growth opportunity and currently has just 4 major players. Yet the rivalry between them is so intense that the players’ profits are on a declining trend.
Threat of new entrants - The higher the barriers, the weaker the threat and greater the pricing power of existing participants. Example: Automobile industry where established players have strong brand and technology are unlikely to see new entrants, implying steady growth in business.
Threat of substitute products or services – Higher the number of substitutes, higher the threat, thus the pricing power of existing participants is low. Example: Print media and Television sectors are gradually being substituted by the digital and internet media (like Youtube, HotStar, etc).
Bargaining power of customers - Lower the bargaining power of customers, higher the sector attractiveness and vice versa. If the number of customers are high, their bargaining power tends to be low, whereas if the number of customers are less they tend to have high bargaining power. Example: Cigarettes - customers are addicted to brand / products giving the manufacturing companies high bargaining power.
Bargaining power of suppliers - Lower the bargaining power of suppliers, higher the sector attractiveness and vice versa. If the no. of suppliers are high, their bargaining power tends to be low, whereas if the no. of suppliers are low, they tend to have high bargaining power.
Company specific factors
Competitive Advantage – Companies which have created an edge over competitors tend to do well over a period. Example: strong brand (Coca-Cola, Asian Paints), distribution network (HUL, Maruti), near monopoly (ITC) or technology (Apple).
Business model – The business environment is continuously changing. In order to be successful, a company’s business model must be flexible enough to accommodate any changes in the business.
Quality of Management – A strong management is likely to steer his company towards profitable growth which is sustainable over longer period. Hence management plays a very important role. Example: recent changes in the management of Infosys have kept the market interested as the new CEO would be the driver for future growth of the company.
Healthy financials – whatever a company does will finally reflect in its financials. If a company is doing good business it will have healthy financials. This can be seen in company’s increasing its revenues consistently, high operating and profit margins, strong cash flow. Good financials will lead a company to earn higher return on the equity / capital employed (RoE / RoCE) that the business requires. This is a key parameter – if a business is able to generate higher RoE / RoCE, there will be very high demand from investors to buy shares of such comapnies.