Today I’m going to write about a complicated topic that confuses many new investors (like me), which is the price of a stock (that is, common stocks traded at stock exchanges around the world).
A stock or a share is an investment instrument that gives ownership of a company. For example if company A has 100 outstanding stock, one share gives a 1% ownership on the company, which allow the owner to vote in shareholder meetings, gives him dividends (when they are distributed) and in case the company goes broke the money left after all assets are sold and debt served are divided between the shareholders (see investopedia’s and wikipedia’s definitions of stock).
So getting to the point, what is the price of a stock? (I’m not sure that this is the correct way to say it… should I say the price of a share? hope this doesn’t bother you, kind reader).
For starters, the current price of a share is defined by Mr. Market. Let’s say you own 1 share of company A and want to sell it at $5, and I am willing to buy this share at that price, then $5 is the price of the share. This is regardless of how much company A earns each year, how many assets it has, etc. The price is defined by the market – by how much people are willing to pay for the stock. This is something that is not usually understood by the new investor, so I will write it once more: The price of a stock is defined by the market supply and demand.
All this is very nice, but how do I know what price should be paid for a company’s stock? This is obviously not an easy question, otherwise the stock market would be a very boring place :-). After reading a lot I have not found a good answer, other than this: you should buy a stock if you think that its future value will be higher than its value today (that is, either it will be more expensive or the company will distribute dividends that increase the return to the stockholder).
OK… but how do I know this?
Well, thing is, you can’t. But there are a number of theories than can help you approximate this. But since it has taken me too much time to finish this post, this will have to wait for the next post.