What Determines the Price of a Stock?

Every business day millions of shares of stock are bought and sold by individuals and institutional investors. Every transaction has two sides, a buyer, and a seller. Each side has a different opinion about the company whose stock they are buying or selling (unless the seller is motivated by a need for cash).

What are the buyer and seller looking at to make their decision?

An easy answer could be the book value of the company. This would be determined by the total assets of the company minus all its liabilities, which would give you the company’s net worth. For example, the net worth of XYZ company is $1,000,000. There are 1,000,000 shares of XYZ outstanding. Therefore, the book value of each share is $1.00.

Yet you look at the current price of XYZ and the current market has it priced at $10.00 per share. You dig deeper and find out that XYZ company paid a dividend in the prior year of $0.50 per share. If the stock were priced at book value, this would be an annualized return of 50%. You look at more information and find out that XYZ has increased its dividend by 10% every year for the past 10 years. Theoretically the price of a stock should reflect the present discounted value of all future dividends. Since the future dividends of any stock are an unknown, opinions of what this number will be vary greatly.

Given the facts you have on XYZ it would not make sense to pay $10 for a share of stock unless you   had a reasonable expectation that the company would be able to continue to increase its dividend every year. The current dividend is a 5% annualized return. In today’s market fixed income, bonds, are available that pay 5% with much less risk than stock.
Back to any transaction in XYZ, the seller believes the growth in dividends will not continue, and the buyer believes it will continue and may even increase in its rate of growth.
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Here is an interesting phenomenon about stock prices and dividends. Tesla has yet to pay a dividend, yet if one bought Tesla 5 years ago, the growth in the price of Tesla’s stock has far exceeded the growth in the price of Apple, Walmart, and many other well-known companies over the same time frame. And these companies pay dividends! What is this telling us? Investors expect Tesla to pay dividends, and lots of them in the future.

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