How does the stock market work? Who decides the price of stocks? What is the logic behind the valuation of stocks?

How does the stock market work? Who decides the price of stocks? What is the logic behind the valuation of stocks?

The stock market can be intimidating, but a little information can help ease your fears. Let's start with some basic definitions. A share of stock is literally a share in the ownership of a company. When you buy a share of stock, you're entitled to a small fraction of the assets and earnings of that company. Assets include everything the company owns (buildings, equipment, trademarks), and earnings are all of the money the company brings in from selling its products and services.

Not exactly. But unfortunately, that's how many new investors think of the stock market -- as a short-term investment vehicle that either brings huge monetary gains or devastating losses. With that attitude, the stock market is as reliable a form of investment as a game of roulette. But the more you learn about stocks, and the more you understand the true nature of stock market investment, the better and smarter you'll manage your money.

Stock exchanges have an interesting side effect. Because all the buying and selling is concentrated in one place, and since it's all done electronically, we can track the constantly fluctuating price of a stock in real time. Investors can watch, for example, how a stock's price reacts to news from the company, media reports, national economic news and lots of other factors.

Let’s start with your last question first— A stock market solves this problem. Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer and the baker. The NSE and BSE are supermarkets for stocks. The NSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to buy and sell.Let’s start with your last question first—how are stock prices determined? Shares in most large established corporations are listed on organized exchanges like NSE or BSE.

Why then do prices fluctuate so much? The vast bulk of stock trades are made by professional traders who buy and sell shares all day long, hoping to profit from small changes in share prices. Since these traders do not hold stocks over the long haul, they are not terribly interested in such long-term considerations as a company’s profitability or the value of its assets. Or rather, they are interested in such factors mostly insofar as news that would affect a company’s long-term prospects might cause other traders to buy the stock, causing its price to rise. If a trader believes that others will buy shares (in the expectation that prices will rise), then she will buy as well, hoping to sell when the price rises. If others believe the same thing, then the wave of buying pressure will, in fact, cause the price to rise.

Every investor who wants to beat the market must master the skill of stock valuation. Essentially, stock valuation is a method of determining the Intrinsic value (or theoretical value) of a stock. The importance of valuing stocks evolves from the fact that the intrinsic value of a stock is not attached to its current price. By knowing a stock’s intrinsic value, an investor may determine whether the stock is over- or under-valued at its current market price.Valuing stocks is an extremely complicated process that can be generally viewed as a combination of both art and science. Investors may be overwhelmed by the amount of available information that can be potentially used in valuing stocks (company’s financials, newspapers, economic reports, stock reports, etc.).

Types of Stock Valuation

• Absolute

Absolute stock valuation relies on the company’s fundamental information. The method generally involves the analysis of various financial information that can be found in or derived from a company’s financial statements. Many techniques of absolute stock valuation primarily investigate the company’s cash flows, dividends, and growth rates. Notable absolute stock valuation methods include the dividend discount model (DDM) and the discounted cash flow model (DCF).

• Relative

Relative stock valuation concerns the comparison of the investment with similar companies. The relative stock valuation method deals with the calculation of the key financial ratios of similar companies and derivation of the same ratio for the target company. The best example of relative stock valuation is comparable companies analysis.

• Dividend Discount Model (DDM)

The dividend discount model is one of the basic techniques of absolute stock valuation. The DDM is based on the assumption that the company’s dividends represent the company’s cash flow to its shareholders.

Essentially, the model states that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends. Note that the dividend discount model is applicable only if a company distributes dividends regularly and the distribution is stable.

• Discounted Cash Flow Model (DCF)

The discounted cash flow model is another popular method of absolute stock valuation. Under the DCF approach, the intrinsic value of a stock is calculated by discounting the company’s free cash flows to its present value.

The main advantage of the DCF model is that it does not require any assumptions regarding the distribution of dividends. Thus, it is suitable for companies with unknown or unpredictable dividend distribution. However, the DCF model is sophisticated from a technical perspective.