Understanding the Fundamental drivers of Share Prices

Demand, Supply and Share Prices

Essentially, stocks and shares are no different from other items of value that people buy and sell every day in markets everywhere. The underlying fundamental drivers of daily movements in share prices are the market forces of demand and supply. By this we mean that the balance between the level of demand for a stock and the supply for that stock ultimately determines the price of that stock.

So, if the supply of a stock (i.e. people wanting to sell the stock) exceeds the demand for that stock (people wanting to buy the stock), then the outcome will be a fall in the price of that stock. On the other hand, if there are more people willing to buy a share at a certain price than there are people willing to sell at that price, the quoted price for that share will rise to reinstate the balance between demand and supply.

In other words, what this means is that the market-clearing price at which the overall levels of demand and supply are in balance is not static and will move again and again to maintain the balance as one of those forces outweighs the other in response to the constant flow of news.

This then leads us to the question of what drives the changes in the level of demand and supply of stocks and shares. What makes a larger proportion of market participants more willing to buy a stock that to sell it (or vice versa) at any particular point in time?

Essentially, this boils down to the flow of new information into the market. As new information comes into the market, market participants (buyers and sellers) reassess their positions and rationale for holding the stock. In particular, if the news is significant enough, they re-examine their valuation of the stock in light of the new information.

Before we discuss the nature of new information that impacts on share prices, it is important to understand how share prices are theoretically determined.

Without going into too much detail about the underlying theory of financial economics, the principal approach to share valuation in the City and on Wall Street is based on what is known as the Divided Growth Model.

Basically, under the approach of the Divided Growth Model, the price of a share is the present value of the cash flows that someone who owns that share may expect over the investment horizon.

What this means is that the current price of a share is simply the sum of the expected value of all dividend payments from owning that share. The expected dividend payments are adjusted for the fact that such payments are to be made in the future rather than today (so £5 dividend to be paid next year is worth less than £5 today due to inflation for instance). The calculation also takes into consideration the expected growth rate in dividends.

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