How is a Stock Price Calculated?

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Stock Prices

  • Stock prices are not calculated in the way that a mathematical formula is calculated. Instead, stock prices are driven by the same factors that drive supply and demand generally, and indeed, pricing of stocks is similar to pricing of other goods. In the stock market, potential buyers of a certain type of stock meet up with potential sellers of a certain type of stock. The bidding process occurs, and however the two parties settle the bidding is the price of the stock that is reported, for example, by stock tickers. There's nothing mysterious here, just classic supply and demand.

Supply and Demand

  • Stock, or partial ownership in the company, is traded every day on the stock market. There are many investments for investors to choose from, and they make their decision based on the expected return for the investment and the risk associated with that investment. No investments are without risk, and those that are more risky tend to have the potential to achieve higher returns. These two trade-offs are the rubric by which investments are analyzed. Companies that deliver high rates of return for their investors are rewarded by upward pressure on share price. In other words, when a company is doing well the demand for that company's stock is going to be strong, pushing the price that the seller can successfully negotiate upwards. Individual investors are responsible for the pricing of stocks and other investments, as the stock market is only the aggregate concrete actions of individuals and other investors (investment groups, other firms and so on).

The Bidding Process

  • In reality, stock price bidding isn't quite as idealistic as it sounds. There are two prices--the ask price and the bid price, and some exchanges actually list both (like NASDAQ). The ask price and the bid price are never the same--the bid price is always going to be slightly lower than the ask price. The two prices actually never have to come together exactly to make the transaction work. The transaction goes on at two prices, and the difference between them goes to the brokerage to pay fees (on top of commission, which is a separate revenue stream for the brokerage firm). In principle, though, this structure is the same as the ideological 'one-price' system described above with some small transactional costs.

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References

  • Microeconomics, 7th Ed.; Pindyck and Rubinfeld; 2009
  • The Practice of Business Statistics, 2nd Ed; Moore, McCabe, Duckworth, and Alwan; 2008
  • Photo Credit http://www.dreamstime.com/profit-loss-chart-imagefree3721693
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