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A company’s stock price is determined by supply and demand. The price of almost every product, commodity, service, and stock is determined by supply and demand. Supply refers to the quantity of a good or service being provided, and demand refers to how many consumers are willing to pay for it.
Before A Company Sells Their Stocks To The Public
Before a company decides to sell a portion of their company to the public through an Initial Public Offering (IPO), the stock price is determined through a process involving the company’s executives, investment bankers, and other advisors. They evaluate the demand for the company’s shares, its financials, and compare it with its competitors to determine the stock price before the company goes public. After the IPO, the main driver of the stock price is supply and demand.
How do supply and demand determine the price of stocks? Or the price of almost everything.
Let’s use apples as an example and relate it to anything you can think of. If everyone loves apples, you can sell them at a higher price because there is a demand for them. But if only one or two people love them, you will have to price your apples lower to incentivize people to buy them, just like sometimes you buy things because they are cheap, not because you want them.
Now, let’s say Louis Vuitton releases a bag with a limited quantity of only 10 in the world. They can price it at a high price, and people will still buy it because there are only 10 IN THE WORLD. Imagine the price would be different if there are only 3.
The concept is the same for stocks. When a company goes public, supply and demand dictate the stock price. If investors think that the stock price will go up because of an increase in demand, they will buy, driving the price up. Conversely, if they think the stock price will go down, they sell, and the price drops.
Why do you need to know this?
Understanding how the price of a stock is governed by supply and demand can help us make better financial decisions when buying and selling a stock.
Share dilution and buyback Stock dilution happens when a company issues new shares, which increases the supply. It increases the total number of shares, reducing existing shareholders’ ownership of a company and affecting metrics such as book value, which may lower the price. The opposite happens when a company buys back shares; it reduces the total shares in the market, which can drive the stock price up.
Pump and dump Since the stock price is determined by supply and demand, there are various ways to manipulate the market. One of them is called pump and dump. Pump and dump schemes usually happen to penny stocks or small-mid cap stocks. People can spread misleading news, which pumps prices up, and they sell off their shares for profit. Market manipulation is illegal but has occurred quite a few times in history, so be careful and look for warning signs. For example, Jonathan Lebed made around half a million from a pump and dump scheme, and Jordan Belfort, the person behind “The Wolf of Wall Street.”
Conclusion As investors, recognizing how supply and demand dictate stock prices is key to making sound financial decisions. While stock price is important, it doesn’t paint the full picture of a company’s value and is influenced by various factors. Understanding the factors that impact supply and demand can significantly contribute to investment success.
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