So this leads to a discussion of what changes the price of any stocks traded on the market, and that is a topic that has puzzled, perplexed and mystified traders since the markets began. What really decides the value of any stock?
Looking at the worst case, the least that shares should sell for is the equity value of any equipment and real estate that the company owns. If the company ceased trading and filed for bankruptcy, these things could be sold and the money shared among the owners (shareholders). The liquidated company is probably worth more than this, as there may be patents, intellectual rights, and other non-physical values. Mind you, the shareholders only get what money is left after everyone else such as regular creditors, bondholders and suppliers have been paid.
Obviously, shares are usually priced much higher than this, on the basis that an operating company has the potential to generate income, and that income translates to value. The value of a share reflects the outlook for future value, and that outlook varies from day-to-day and depending who is buying or selling. In truth, the value depends simply on what the “market as a whole”, that is the collection of all traders and investors, thinks it should be. Market sentiment is the term usually used to describe this. We’ll come back to discussion of share valuation later.
Bonds
As a brief diversion, you should note that companies can issue bonds, as well as shares. Bonds are totally different from shares, as they are simply debts. As long as the company does not go bankrupt, bonds must be repaid. The company is issuing a bond so that it can borrow your money, and will pay you interest for the use of the money. This is another way that the company can raise the funds that it needs, and in this case it is not giving away any control such as goes to shareholders.
Even though bonds represent debt for a certain amount, you will find that the price of a bond can vary over time. When the bonds are redeemed, then the set amount must be repaid; but bonds usually have a set rate of interest when they are issued, and it depends how competitive this rate of interest is as to the value of a bond during its life.
As an example, suppose you have the choice of buying £100 (face value) bonds in company A which pay interest at a rate of 6% per annum, or buying £100 bonds in company B which promises an interest rate of 3% per annum. Both bonds were issued a couple of years ago, and both mature and pay back the capital in two years time.
Assuming that both companies were equivalent in your view in terms of security, and basically you trusted them to pay out on the due date, you would obviously buy the bonds in company A, if both were available to you at the face value of £100. You can look forward to two payments of £6 interest, and to getting £100 repaid in two years. If you bought the bonds in company B you would only get a total of £6 interest over the two years, and then £100 paid back.
So to even up the deal, you will find that the higher interest bonds would be available at a “premium”, that is more than the face value, and the low interest bonds might change hands at a “discount”. Say that 6% interest is a good rate, and higher than you can get on anything else, then you may even decide you could pay, say, £103 for each £100 bond from company A. This would be a £3 premium. In two years you finish up with £112, so you would make £9 profit over time.
On the other hand, say that 3% interest is poor in the current market, you might only offer to pay £97 for each £100 bond from company B. In this case there is a discount of £3. In two years you would have received a total of £106, so this is again a £9 profit, making this deal as attractive as company A (actually slightly more attractive, as you only have to commit £97 compared with £103 to buy the bond).
Admittedly, this is an oversimplification, but shows you the principle by which bonds can vary in price over their lifetime. Many people do not realize this, thinking that bonds are a fixed and reliable investment compared with their brethren stocks, which are the ones that change value. It is true that, barring bankruptcy, bonds are more reliable at paying out in the end, but that does not mean that the value of them doesn’t fluctuate with time.
If you are interested in a fixed interest income return which is usually better than savings accounts, then you can also look at government bonds, which are available for various terms and amounts. They are often called “gilts” in the UK, and the US version includes treasury bills and notes. Government issued bonds have the additional security that a country, or at least a municipality, is standing behind them and guaranteeing that they will be paid back. Sometimes you’ll even get favourable tax treatment for investing in government bonds. The interest rate set by these notes is often used as a yardstick to measure other returns.
The Stock Exchange
The London Stock Exchange is the trading market for many familiar British companies. There are more than 2,400 companies listed there, 1600 of which are incorporated in the UK, and with a total market value in mid-2013 of nearly £4 trillion.
The market is summarized sometimes with “FTSE” indices (this is pronounced Footsie). FTSE stands for the Financial Times Stock Exchange index, and there are several of them. The most common one is the FTSE100 which is an index price based on the top 100 companies on the exchange, that is the 100 companies that are worth the most. At the present time, every one of these companies is worth more than £2.9 billion. The value of a company, the total number of shares available multiplied by the share price, is also called “market capitalisation”, so these may be called “large cap” companies.
Another FTSE index that is often used is the FTSE250. This is formed from the share prices of the 250 next largest companies, referred to as “mid-cap” companies. They are not particularly small however, as the value of these companies varies from £¼ to £2 billion. (Large caps go up to a value of £140 billion, with Royal Dutch Shell being the largest UK company at the moment). The FTSE350 is a combination of both sets of prices. If you are investing for the long-term in the markets, you may decide to stick to some of these first 350, as smaller companies tend to be riskier.
The London Stock Exchange has a special listing for companies that are much smaller or for some reason do not satisfy all the listing requirements of the main exchange. This is called the AIM, or Alternative Investment Market. The companies on this can be small and highly risky, and there are no minimum capitalisation requirements such as are needed for the main market.
Some people get confused by the idea of buying stocks in a company, thinking that the company benefits from their purchase – it doesn’t. Once the public offering is over, the stocks and shares are simply traded on the markets between different individuals or investment groups, and whether, when, and for how much they change hands has nothing to do with the company or its finances. They could halve or double in value and the company would still be there, producing its widgets at the same rate and charging the same price.
How the company performs will have an impact on the share price however, though it is not always possible to predict how various pieces of news will affect the numbers. Remember, the value of the shares depends on market sentiment towards the company, so if it looks as if the company is going to make great profits, which could quite possibly translate into large dividends for shareholders, then there may be a demand for the shares which would push the price up. If the company is in the doldrums, with no one wanting to buy its product line, say manual typewriters, any more, then you could reasonably expect that the shares would be sold off cheaply, as they have little prospect of making money in the future.
If only it was that simple, the markets would be predictable enough that many people would make a killing. However it isn’t, and the expectations of the market can have a major effect. For instance, the company may declare a great profit and the share price fall. Why? Because the buyers and sellers had expected the profit to be even larger, so they were disappointed and decided to sell. Or there can be bad news but the price stays up, as the news might have been and was anticipated to be worse than what actually happened.