The Formation of Stock Prices

Abstract

In this chapter, we explain the formation of stock prices. In real life the intrinsic value of a stock is unknown. Therefore, an investor must include the appropriate factors and uncertainties to estimate the cash inflow and outflow, and the discounting factor. As a result, fundamental investors attempt to understand a business to determine roughly how they will perform in the next 10–30 years by setting assumptions of how competitive forces can shape the company, as well as what the demand of the company’s products and services will be, including the company’s ability to perform throughout a business cycle. Fundamentally, the more disparities there are in the aggregated assumptions of the investors, the more shares of companies are traded, and the more stability of assumptions, the fewer shares are traded. All stocks have a daily volatility level, which is irrelevant for IR, as it cannot be tampered with. A relatively higher volatility is typically the result of an increased uncertainty in the financial market about a company’s future. However, best-practice IR can provide significant value to a company in terms of added market capitalisation in the event that a company’s volatility and risk premium is reduced.