What Goes Into a Stock Price?

Stock price is one of the first things that investors look at before establishing a strategy, but what goes into it? How does a stock get a price in the first place? Reda Farran, Global Markets Analyst at Finimize joins Cassidy Clement to discuss all that more!

Summary – Cents of Security Podcasts Ep. 74

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content and Interactive Brokers and today I’m your host for our podcast. Our guest is Redda Farran, Global Markets Analyst at Finimize. Stock price is one of the first things that investors look at before establishing a strategy but what goes into it? And how does the stock even get a price in the first place? We’re going to discuss all that and more. Welcome to the program, Redda.

Reda Farran:

Hey, good to be here. Thank you for having me.

Cassidy Clement:

Sure. So as this is your first episode on the show, why don’t you tell our listeners a little bit about your background and how you got started in the industry?

Reda Farran:

Yeah, sure. I mean, I studied finance all the way, like through my undergraduate, through my master’s, et cetera. I worked initially between my undergraduate and master’s on the sell side for a little bit, just for a year. But then really after my postgraduate degree, I worked in investment consulting. So working with pension funds on things like portfolio construction, allocation, et cetera. Before I switched and joined Fidelity as a Buy Side Equity Analyst, where I was covering, different sectors in North America, predominantly energy, utilities, renewable energies, things like that, etc, etc. Before kind of switching to FinTech, which is Finimize, where I’m currently a Global Markets Analyst. And I’ve been, yeah, interested in investing and have been investing for a long time, initially through a paper portfolio, but obviously a lot more recently with real money and funnily enough with Interactive Brokers, actually. So you are my broker of choice. So good to be here. Absolutely.

Cassidy Clement:

Well then you found your way to the right podcast, I guess. So, you know, in this episode, we kind of want to explain to our listeners what is going into a stock price both before it hits the market and then after? Because as you and I know, especially if you read any financial news, there is so much that can go into influencing it or making up the, elements of the formula that bring that number to what it is.

So let’s start a little bit earlier in the timeline, let’s say, for the stock. So what exactly would be the process for an IPO to have a price established before it hits the market or right as it hits the market?

Reda Farran:

Yeah, sure. So, look, I mean, first of all, from a kind of retail investor point of view, I think the pre-IPO pricing, retail investors are really out of the picture. That process is predominantly institutional based. And what I mean by that, it is the particular company in question that wants to go public, they go to investment banks. And tell them, hey, look, we want to have an IPO, we want to raise funds, et cetera, et cetera. The investment banks keen to, you know, make a good amount of commissions, basically take that company on a roadshow. They basically link meetings between the company who wants to go public and prospective investors. Those respective investors are, more often than not, we’re talking about institutional investors. So think about the Fidelity’s, the BlackRock’s of the world, think about hedge funds, et cetera, et cetera. So then they have those kinds of meetings and the investment bank who really is kind of running point on, you know, trying to determine the valuation, trying to determine at what price the stock will go at, will IPO at. It’s kind of trying to gauge the investor demand through those meetings. So, you know, if you’ve got a really hot company that’s in a big growing theme and that particular company will potentially be the only pure play stock, you know, publicly listed stock to play that theme. And as you can imagine, there’s going to be a lot of investor demand and they can kind of upsize, or basically, you know, IPO that particular company at a high valuation. First things first, to kind of really summarize that, is really kind of supply and demand. So how much of the, how many shares the company is trying to, you know, kind of issue in its IPO?

And then what is the investor demand for that particular IPO? Especially from the institutional side of things. So that’s one of the key criteria. The second key criteria that obviously a lot of investment banks, you know, plug into their IPO models, etc, is what valuations are similar companies in the industry trading at? So if you are let’s say a cloud computing company that wants to go public well, the very first thing that the investment bank is going to do is basically look at current, you know, publicly traded cloud computing stocks, look at their current valuation multiples, so basically multiples of revenue. It could be, you know, enterprise value relative to revenue, it could be price to earnings, so the market value of the company relative to the profit, et cetera, et cetera. Calculate an average and then apply that to the company that’s going to go public. But, and this is an important note, and maybe we can kind of touch on it later in the podcast. It’s, you know, sometimes they could apply a premium or a discount to that valuation, depending on how the company going public looks relative to its peers.

Cassidy Clement:

Yeah, I mean, that kind of encapsulates how you’re getting to, we’ll say, the beginning of the marathon that is a stock having its life on the market. So once it gets into the game here and it starts to be on the market for most people, the retail investor we’ll say, to get into the action here, you know, what exactly would determine the stock price after? There’s a lot of ebb and flow. Everybody always talks about volatility, but I mean, from the economics 101 perspective, we of course look at supply and demand, some fundamental and technical factors. And then of course, where we are economically with inflation, deflation, and then, you know, if there’s an economic label at the time, meaning a recession or a depression, but what exactly determines that stock price?

If we were going to dive into that a little bit more of what’s impacting the price once it arrives on the market, because as we all know, they can go up and down once they arrive. It’s not that they stay the same or always go up.

Reda Farran:

Yeah, absolutely. It’s a great question. Let me try to answer that by focusing on three timeframes. The first timeframe is literally the, on the day that the stock goes public. And then I want to focus on what happens in the short term and then what happens in the long term. Usually what happens on the day the stock goes public, so this is, you know, the first day the stock hits the stock market, you’ll find the company’s management team in the New York Stock Exchange ringing the opening bell. It’s a happy moment for everyone. And usually what you find is that the stock price pops, and there is several reasons for that, but one of the key reasons why is that, like I said, in the IPO process, unfortunately, retail investors are excluded from the process. Excluded from, you know, meeting the company and trying to buy shares in the company, and they’re excluded from actually gaining an allocation in the IPO. So retail investors cannot subscribe to IPOs more often than not.

So basically what happens on the day that the stock goes public is that you have all these retail investors who are keen to buy that particular company’s stock. They couldn’t obviously through the IPO process. But suddenly it’s listed, everyone jumps onto their brokerage platform, tries to buy the stock at the same time, and you get, you know, the stock basically popping on day one. Because you had this big crowd of investors who wanted to get in, couldn’t get in, and the only way they can get in is to buy it on the open market after it starts trading. So that’s usually what happens kind of on day one. And then once a stock is public, what determines its price, really there are kind of two sort of main ways to look at it, short term and long term.

Let me kind of just focus on the long term first, and then I’ll touch on the short term. In my opinion, in the long run, the key thing that determines a company’s, you know, stock price, its valuation, is ultimately its fundamentals. So, how good of a company is it? How is it operating, what are its profits, how much cash flow is it producing? Is it paying a dividend, how does it compare to its peers, what industry is it operating in? Is that a growing industry, is that a declining industry, how good are its management team? So in the long run, ultimately, a company’s valuation converges to its fundamentals, okay? The key thing really to bear in mind here is that the most important thing that determines a company’s valuation is its future outlook, not its past. It doesn’t matter if you’re once upon a time, you know, the best company in the industry in the world, in that particular industry. But if you’re on the road towards bankruptcy, you’re going to end up having a very low stock price, a very low valuation. So the key thing really is the future outlook. So in the long run, company prices, company valuations really kind of converge and match with the company’s underlying fundamentals. But in the short run, a lot of other factors are at play, such as investor sentiment, such as momentum, psychology, crowding, et cetera, et cetera.

So, for example, AI is a really hot, you know, theme, really hot topic at the moment, and if you look at a lot of the AI stocks at the moment, they have done incredibly well. They’re trading at extremely high valuation levels because that’s the current, you know, short term sentiment. Now, is that a true reflection of their long term worth? Time will tell. But you know, that’s how kind of prices get impacted sort of in the short term. In the short term, a lot of it is really determined by investor sentiment, positioning, things like crowding, psychology, etc, etc but in the long run, fundamentals prevail and what the company is intrinsically worth should align with its price in the long run.

Cassidy Clement:

So that actually leads me to my next question, because most people when they hear that, when you’re like, okay, well, it says $50, but there’s all these other factors. And to me, it might seem like $25, but to my friend, it might seem like $75 in terms of the value. So can a stock actually be undervalued or overvalued, or maybe I guess in layman’s terms, a cheaper buy versus a more expensive buy.

Reda Farran:

Yeah, no, I mean, absolutely. Look, the main way to make money in investing in my opinion, is to find those opportunities where a stock is kind of undervalued. And, you know, buy them or, you know, find opportunities where a stock is, you know, overvalued and either kind of avoid it or if you know you’re willing to take on higher risk strategies, even potentially short. Now we live in a day and age, like compared to, let’s say 30, 40 years ago, finding mispriced stock opportunities is a lot harder these days simply because access to information has, you know, become really unbelievable right over the past 40, 50 years. If you think about professional investment analysts, let’s say 40, 50 years ago, they would literally go let’s say outside, you know, Macy’s and kind of count the number of people going in and out of the store to try to kind of get some informational edge on the company and therefore kind of inform their investing. Today, that’s a lot harder because you have a lot of information out there, and you have a lot of analysts, you have a lot of professional investors, retail investors, all looking at the same information, analyzing the same information, buying and selling stocks, etc, etc.

So it’s important to note that finding genuinely very obvious mispriced stocks is is a lot harder these days, simply because the market is more efficient at, you know, fixing these kind of mispricings. Having said that, that doesn’t mean they don’t occur. They do occur. There’s, you know, always a lot of opportunities, to find mispriced stocks. And, obviously, particular companies can be overvalued or undervalued for different reasons. So on the overvalued perspective, I kind of already touched on this and provided an example, when a particular theme is really hot at the moment and all investors are crowding into it, that can lead to a lot of companies being overvalued. I don’t want to repeat AI because, you know, the jury is out yet on whether, you know, these companies are generally overvalued or not, because, you know, we’re still only scratching the surface of what this technology could potentially do. But look, let’s look back at the dot com bubble, right? Any single company in the late 1990s that just, you know, rebranded itself as an internet company suddenly got its stock price double, tripled in a matter of months, became extremely overvalued, the bubble burst, and all these companies ended up being worthless.

On the other hand, you know, in terms of companies being undervalued, that can also happen a lot, especially companies are current going through kind of short term, turmoil. And that kind of leads a lot of investors to sort of, avoid them, for example, because, Unfortunately, I’d say a lot of investors are kind of short term focused and they don’t kind of take the long term perspective. So if a company is kind of going through sort of short term troubles, a lot of investors can just sort of dump its stock and say, okay, whatever, I’ll just wait till things get better in the long run. Companies can also be undervalued if the particular industry is experiencing some trouble. Let’s say, for example, you know, energy, quite cyclical, so let’s say, you know, oil prices are quite depressed, that can lead to a lot of energy companies being undervalued, relative to long term fundamentals, etc., etc. So there are a lot of reasons out there why companies could be overvalued or undervalued. Relative to the broader market or even relative to their peers. And I think that’s where interesting investment opportunities really come up if you can find those mispricings.

Cassidy Clement:

You mentioned a few times about, the underlying business and or, the broader market space for that industry. AI was an example. Energy is an example. So, a lot of terms accompany the conversation about stock price. I mentioned some economic labels, you had mentioned the industries. Another one was of course the value, but market cap or market capitalization is another one that you hear a lot when people are talking about the business that’s underlying that stock price. So how exactly does market cap influence the stock’s price?

Reda Farran:

Yeah, I mean, if you think about market cap, what market cap tells you is basically the total value of the firm, the total market value of the firm, right? Which is basically you take the stock price, you multiply it by the number of shares outstanding and you get the total market value of the firm. Which is arguably more important because if you think about the stock price, it’s kind of arbitrary, right? So if you have a business that’s worth a hundred million dollars, I could, you know, issue, a million stocks, each one kind of worth a hundred, or I could kind of divide it in any other way. So that’s why people look at market capitalization, because If I just tell you this stock is worth $50 or the stock is worth $1,000, you know, I know Amazon is worth more than that stock price, for example. That doesn’t really tell you much, right? So what market value kind of tells you is the total value of the firm, which basically is a lot more meaningful. And then what makes things a lot more meaningful when comparing different stocks is somehow, comparing apples to apples and normalizing these value metrics.

So, let me just kind of give you an example. If I tell you this stock is $50 and the other stock is worth $300, that doesn’t mean the one that’s worth $50 is cheaper than the other one. Because what you really want to do is you want to compare things relative to their underlying size. So relative to their, let’s say, profitability. So let’s kind of make this a clearer example. Let’s say I tell you this particular house is worth, you know, $100,000. This house is worth a million. That also doesn’t tell you much about value. Because, you know, if the $100,000 is a tiny studio, and the million is like a big mansion then that makes complete sense, right? So how do we kind of cross compare houses to factor in size? We look at metrics such as dollars per square meter, right? So that’s a much more meaningful metric to kind of assess the relative value between one house and another. If I quote things on a dollars per square meter or per square foot then that gives you a much better idea on the relative attractiveness of one house of another.

So very similar to companies, the way we normalize across them is by quoting things relative to, let’s say, a dollar of revenue or to a dollar of profit. So the price to earnings ratio, for example, it basically divides the entire market value of the company by its net income. And it kind of tells you how much a dollar of profit is worth, how much you have to pay for a dollar of profit for the particular company. And, you know, it kind of makes things easier to compare on an apples to apples comparison. So, going back to that example, $50 stock and $300 stock, but maybe that $50 stock trades at a PE ratio of 50, for example. Whereas the $300 stock trades at a PE ratio of 10. So actually that means that $300 stock is much cheaper because relative to the PER how much you’re paying per dollar of profit for the underlying company you can get that much cheaper.

Now there’s something really important to kind of bear in mind when you compare these metrics or these valuation ratios across companies. So if you’re comparing the price to earnings ratio of a particular company relative to its peers in the industry, let’s say a particular company has a higher PE ratio than its peers. That doesn’t automatically mean that the stock is more expensive and you should avoid it. I think one of the very key things that investors should understand is that some companies they justifiably have a higher PE ratio. And anything that makes the company better relative to its peers justifies it trading at a higher PE ratio relative to its peers. Remember, the PE ratio is basically telling you how much you have to pay for one dollar of profit of the underlying company. But if that dollar of profit for company X is actually much better than company Y because it’s less risky, it’s growing faster, etc, etc, it only makes sense that you pay a higher multiple on that dollar of profit.

Going back to the house analogy, right? If you have, you know, one house, let’s say, $1,000 per square meter, then you have another house that’s much more modern, in a better neighborhood, better connected transport wise. It’s only fair you pay higher than $1,000 per square meter for that house because it is fundamentally a better house. That’s the key thing to kind of bear in mind. So that kind of begs the question, all right, what kind of factors justify a higher PE ratio? Why should company X trade at a higher PE ratio relative to its peers? And there are many factors. If that company has faster earnings growth, for example, that justifies a higher PE ratio. If it has a better management team, same thing. Again, you’re willing to pay more for that dollar profit because it’s a more defendable kind of profit, better profit margins. Let’s say for example, you know, scores better on ESG factors because that’s something kind of investors care about these days, et cetera, et cetera. So that’s something to really bear in mind. Yes, definitely you should always compare the PE ratio of the stock you’re looking at relative to its peers, relative to the industry. But you know, don’t just take it, you know, at face value that, hey, if this PE ratio is lower, that means it’s cheaper just like that or if it’s higher, it means it’s more expensive. You have to ask yourself why? Why is this company trading at a higher or lower PE ratio than its peers? In some cases, it’s justified. And if it’s not justified, that’s where the interesting investment opportunity arises.

Cassidy Clement:

So you mentioned a bunch of really good metrics and items to keep in mind in addition to market cap to kind of round out your understanding of a stock, whether it’s for, understanding the business itself and then how it got the price, or just if you’re somebody who knows a lot of these financial metrics, getting right to it and checking out how it got to that price.

What other important questions or metrics should investors look to before making a move on a stock for price alone? I mean, usually you would want to know their model for profit, like their business model, any demand, any industry performance, what other elements should people be looking for or questions they should be asking themselves before they just jump because they think something’s undervalued?

Reda Farran:

Yeah, absolutely. And it’s a very good question because obviously there’s a lot of emphasis on quantitative analysis. So kind of looking at, You know. Numbers looking at profit margins, the PE ratio, et cetera, et cetera. But I feel like unfortunately qualitative analysis is underappreciated and I think qualitative analysis of a particular company is equally as important. So you mentioned some things already that we kind of mentioned throughout this, recording to things such as the quality of the management team. I think it’s super, super important. At the end of the day companies don’t run themselves, they’re run by people like you and I, and it’s really important to assess the quality of the management team. To assess their incentives, look at their pay structure, are they incentivized to drive long term shareholder value or are they just incentivized to grow the business no matter what the profitability looks like. There’s a phenomenon called empire building which is quite unfortunate. Another really important thing to look at is the industry, so the industry as a whole that the company operates in and how that company is positioned in the particular industry. So think of factors such as, you know, barriers to entry, right? If you operate in an industry with high barriers to entry, that’s quite attractive.

That means, you know, competition cannot spring up overnight and basically eat your pie, right? Eat your cake. If the bargaining power of, you know, your customers and your suppliers, et cetera, is quite low, quite attractive. If the level of competition is cutthroat in the industry. That’s, you know, not really good because that can basically lead, you know, profits of all the firms kind of declining because everyone’s trying to compete on price, et cetera, et cetera. So doing a qualitative analysis on the particular industry, I think it’s also super, crucial. And then I think one of, you know, definitely not an exhaustive list, but I think one of the most important qualitative things to look at, if not the most important, in my opinion, is the risks, the potential risks.

Everyone is focused on the upside. Everyone’s trying to find that stock that’s gonna, you know, be the next NVIDIA, that’s gonna double, whatever, whatever, whatever. But no one pays enough attention, in my opinion, I’m really talking about the kind of retail investor space. No one pays enough attention on the potential downsides. What could go wrong? And I think no investment thesis is complete without considering the potential risks. So as you’re kind of analyzing a stock and, you know, listing all the reasons to buy, all objectively, etc. I think it’s also really worth making a list, both mentally or written or whatever, on what are the things that could potentially go wrong?

What are the key risks? And I think it’s really, really important that you kind of monitor those if you’re invested in a stock. And if you see something, you know, becoming bigger and bigger of a risk, then I think it’s time to kind of, you know, swallow your pride, cut your losses and sell the stock. So let’s say for example, you’re invested in a new EV company and you’re seeing one of the big risks you highlighted is EV competition. It’s heating up. Companies are trying to underprice each other, etc, etc. And then this particular stock I invested in, which is a relatively new EV company. You know, doesn’t have the economies of scale to basically, you know, compete on price with some of the others. That’s a big risk. And that kind of happened, right?

If you look at the past two, three years, ev competition really heated up. You had some high profile bankruptcies, FISKER for example, in the US, et cetera, et cetera. So make a list, really try to understand and study the risks and if you read the annual reports of any company you invest in, they have a massive section dedicated to risks.

So it’s not like you have to do a lot of analysis yourself because the companies in their annual reports actually provide a long list of risks that are most important to them and their industry. Pay close attention to that section of the annual report because success in investing doesn’t just come down to, you know, making good money in stocks that you get right, but also means avoiding huge losses in stocks that you get completely wrong.

Cassidy Clement:

Yeah, that, that’s a great point, in terms of looking at the what can go wrong area. There’s a few other podcasts that we have done, we always have subject matter experts on as our guests. And that’s something that most people, who are analysts or let’s say journalists, they always double down on that saying, even if you go out and you find that this is the greatest thing in the world for your first batch of research, go out and find three more things about why it’s the worst thing in the world and just see how it’s going. I know for a lot of young, or new investors out there, you go out, you learn how to research. You maybe go to write a research paper in college, and you search everything to support your argument. You are usually not searching for things that discredit your argument, and that’s something that.

Right. And you don’t want to cause a confirmation bias when it comes to something that might be, you know, an investment for your retirement or something larger, you know? This is a very important thing and I think you gave our listeners some really good points today. So thanks for joining us.

Reda Farran:

Not at all. It’s been a pleasure. Thank you once again for having me.

Cassidy Clement:

Sure. So as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening, everyone.