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Narrator: Hey everyone, I'm Cameron May, an education coach here at Charles Schwab. Welcome to Comment Below, where we answer questions directly from YouTube.
Today's question comes from Aiden Meyer who asks, "Could you guys explain the ins and outs of who is responsible for setting a stock price and the factors that are considered?"
Great question, Aiden. Let's dig into it.
No one sets a stock's price, exactly. Instead, the price is determined by supply and demand, like any other product or service.
There's always a buyer and a seller with every transaction, but when a lot of people buy a stock, the price goes up. When a lot of people sell it, the price goes down.
If you bought a stock at $49 per share, and the price rose to $55, it's because a lot of other people were interested and buying it too. If circumstances changed, and the price started falling from $55, shareholders are selling.
That means the price you're seeing right now is the last transaction price between a buyer and a seller. It can change quickly, too, especially for popular stocks, which sometimes trade millions of times a day.
But let's rewind and look at how a stock's starting price is established before all that trading begins.
When a private company's executives decide to trade its stock publicly, investment banks—referred to as the underwriters—will scrutinize its financial records to get an idea of the business's value.
They'll look at how good it is at making money, its expectations for future earnings, valuations of similar companies within the same industry, and investor demand for the stock. That assessment—known as a valuation—is important to any stage of investing.
Based on the valuation, the underwriters will decide on an initial price to offer shares to the public. Those new issues are then sold during an initial public offering, or IPO. Once it issues shares in the IPO, investors can trade those shares for a higher or lower price on the stock exchanges.
After a stock is trading on the open market, there's a bunch of reasons that investors choose to buy or sell it, including the business's operations, the narrative surrounding a company, and technical aspects of trading.
Earnings calls detail a company's financial results generally every three months. They provide insight to investors on a company's past, present, and potential future performance.
Investors buy a stock because it gives them a right to share in the earnings, like dividends or price appreciation. Investors don't just buy a piece of a company's current earnings but a piece of the company's potential future earnings.
A metric to determine how much of a stock's price is based on future expectations is the price-to-earnings, or P/E, ratio.
The PE ratio compares the current price per share of stock to the company's earnings per share, or EPS, over the last 12 months. For example, a PE of 20 means that investors would be willing to pay $20 for every dollar of earnings. Keep in mind that stocks have both trailing and forward-looking P/E ratios, which can tell you how much earnings are expected to grow in the coming year.
A high PE suggests that investors expect earnings to grow rapidly and that they're willing to pay a lot to get a piece of that potential growth.
In early 2020, the electric car company Tesla, had a PE of negative 94.73, while GM's PE was 6.05, and Ford's was 24.97. Meaning even before it was profitable, Tesla was valued higher than Ford and GM, suggesting many investors had high hopes for its future earnings.
Chart: U.S. automakers market cap on January 6, 2020. Tesla's was over 80 billion dollars, GM's was about 50 billion dollars, and Ford's was about 30 billion dollars.
Narrator: Future earnings aren't guaranteed when dealing with high-flying stocks. High prices can be driven by speculation and narrative.
When news started coming out in 2023 about the potential impact of Nvidia's AI chips, its PE ratio skyrocketed to a height of more than 240 in July from less than 60 in January. But it seems it wasn't just the narrative: There was a boom in sales, too. In 2024, Nvidia helped push major indexes to all-time highs.
Chart: NVDA P/E ratio, January 2023 through January 2024. Between January and July 2023, NVDA's P/E ratio rose from around 60 to over 240. But after reporting earnings in mid and late 2023, the P/E ratio fell back to prior levels as increased earnings per share reduced the P/E ratio.
When there are situations where the sales don't match the narrative and investors buy anyway, it can be a part of herding behavior, like the infamous influx of investors into meme stocks.
That can cause prices to spike or plummet without an obvious reason and can result in substantial losses for investors who don't do their research.
Plenty of other things can cause investors to buy or sell, too, like breaking news about a company. An announcement about a new product might push investors to buy, while an admission of a failed one might be reason to sell.
New government regulations might change the way a company's industry operates for better or worse.
Other factors that can influence a stock's valuation include the current interest rate, or risk-free rate, where the economy stands in the business cycle and overall investor sentiment.
Investors can also measure the movement and momentum of a stock. They'll look for patterns and trends in a stock's historical price chart—signals that might influence a decision to enter or exit a trade. It's a field of study called technical analysis, and many investors who use it believe that a stock will generally continue in the same trend, or direction it's been going—up, down, or sideways.
Thank you for the excellent question, Aiden. It's a question a lot of people have when they're starting out. Even if you're a more advanced trader, it's always smart to refresh your memory on foundational parts of investing.
You can find plenty of additional educational content on the Charles Schwab YouTube channel and under the Learn tab on schwab.com.
To anyone who's curious about something related to finance or investing, please leave a comment and ask—you just might be the inspiration for the next Comment Below video.
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