Stock prices tend to change quite frequently. We are often told that demand and supply forces in the stock market determine a stock’s price. But, in the context of the stock market, what is ‘supply and demand’? What factors can affect the demand and supply for a stock? What makes a stock valuable?
We answer these questions in this blog. Read on to find out how stock prices are determined in the stock market.
How do supply and demand affect stock prices?
Demand and supply play a critical role in the determination of stock prices. At a certain stock price, when more quantity is demanded than the supply, the price will increase till the quantity demanded and supplied match.
In theory, demand for a stock increases if the market participants find it more desirable. Similarly, the stock supply increases if the stockholders feel the stock price is at a peak or will fall. When more people want to sell, the supply of the stock will increase.
So, what determines the demand and supply in the stock market?
Factors affecting a stock’s demand and supply
Any event that affects the profitability of a business will influence the demand and supply of a stock. Some events will affect the whole economy and the profitability of nearly all businesses. COVID-19, disruptions in the supply of key materials like oil, food, etc., are some examples of events that may affect the whole market. It should be noted that not all businesses will be affected to the same extent and in the same direction.
Other than events that might affect the demand and supply of all stocks, industry-specific and company-specific factors may affect a stock’s demand and supply.
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Industry-specific factors influencing demand and supply of stock
Various factors can affect how attractive a particular industry can be for investors. Some of the industry-specific factors influencing the demand and supply of a stock are listed below:
Growing industries or industries in their infant stage are expected to grow if they get the necessary support from complementary industries and the government. Stocks of such industries might experience high demand.
Every industry has an estimated market, but industries may not capture their total estimated market. Market penetration measures how much of the total estimated customer base the industry is reaching. Movements in market penetration will affect the desirability of a stock.
Production-linked schemes and protective policies for growing industries are some government measures that can make an industry profitable. At the same time, over-regulation can stifle an industry’s growth.
Bargaining power of suppliers and customers
Suppose customers can bargain a lower price for the product, or the suppliers can bargain a higher price for the raw materials. In that case, an industry’s profitability will be lower. If suppliers and customers have lower bargaining power, an industry’s profitability will be higher.
The strength and number of substitutes for an industry will affect its desirability.
Level of competition between firms
Suppose there are various firms in an industry constantly competing in an industry. In that case, expenses might be high for research and development and marketing. At the same time, the bargaining power of suppliers and customers will be high.
On the other hand, monopolies have high bargaining power over suppliers and customers. The pressure for research and development and marketing will be lower.
Also read: Why Do Stock Prices Fluctuate?
Company-specific factors influencing demand and supply of stock
Various company-specific factors can influence the desirability of a company. Some of them are:
To stand out in the market, a company needs to establish an edge over its competitors in terms of efficiency, market share or profitability to attract investors. Companies with a higher market share will have less variation in demand. Companies with high profitability might pay higher dividends to investors. Companies with smoother delivery of their product might lose out on fewer potential customers.
Typically, a company with a well-modeled and dynamic business model will be desirable to investors. Business models that can adapt to changing demands from customers and have fewer variables that can affect profitability are desirable. For example, suppose a company has tie-ups or merges with its suppliers. In that case, it can have a smoother delivery of its products. At the same time, if it has production facilities that can adapt to customer demands, there will be less volatility in demand for its product.
How does debt affect stock price?
Companies that rely too heavily on debt are not desired by investors. Well-managed debt can increase profitability, but too much debt can leave a business vulnerable to debt cycles and increases in interest rates. Debt levels affect how desirable a company is for investors.
How does company performance affect stock price?
Movements in a company’s market share and efficiency in turning profits can affect how desirable they are for investing. Typically, a higher market share and higher efficiency in earning profits are desirable. There are various ways to understand how a company is performing. Revenue and earnings per share are often quoted as measures of a company’s performance.
How does revenue affect stock price?
When a company’s revenue rises in comparison to its competitors, it becomes more desirable in its sector. Companies with growing revenue might see high demand from investors.
How do company earnings affect stock prices?
Every investor expects returns from their investment in a company. Suppose a company starts showing higher earnings per share than companies in the same industry or market cap segment. In that case, it will become more desirable for investors.
A stock’s price represents the real value of future income from a stock. So, in theory, any event that affects a company’s profitability would affect its price. At the same time, you must also consider whether the company will be as profitable as other companies listed on the stock market. Companies in the same sector will compete for customers as well as investors.
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If an industry is profitable, has growing market penetration, and has weaker substitutes, it will be desired by investors and vice versa. The desirability of an industry affects the stock prices of the companies in that industry.
Stock prices are considered to be functions of the demand and supply of a stock. The demand-supply of stocks depends on whether the market feels the stock price is appropriate for its expected earnings.
In theory, it is better to buy stocks at their lows and sell them at their highs. However, it can be very difficult to tell when a stock is at a low from when they are in the middle of falling to a low.
Buying and selling a stock on the same day (day trading) is not illegal. However, day trading strategies tend to be very complex and have to be carried out within very short timeframes. So, they require high experience.