How are share prices determined

The stock market is a glorious demonstration of the laws of supply and demand. In classical economics, prices rise where there are more buyers than sellers, and vice versa. On a basic level a share price change indicates an imbalance between buyers and sellers.

In highly regulated and liquid markets, like the London Stock Exchange, it is assumed that all available information which might affect the price is known in the public domain. When information arrives which affects earlier assumptions built into the share price, it is likely to change.

It is important to remember that news can be interpreted in a number of ways. However, the market is always quick in finding consensus on new information. It is crucial that you understand the effect of new information on different sectors. Certain stocks are particularly sensitive to specific types of news. For instance, gas prices have a large impact on the share prices of electricity generators. Investing in shares is a big commitment and requires you to take a critical interest in any relevant market information.

Professional investors, the financial analysts, employ clever mathematical techniques to arrive at an estimate of the future price of company shares. Since the value is based on the analysts' assumptions, the outcome can be different from that expected. When an assumption turns out to be wrong, the analyst will have to re-evaluate the price he has placed on the company, as the effect of the change will ripple through the model.

Based on their opinions, analysts will given recommendations, ranging from positive to negative – the standard jargon on this scale is: Strong Buy, Buy, Hold, Sell, Strong Sell. The meanings are fairly self-explanatory though they differ from analyst to analyst even though they mean the same thing.

Without relying on the professionals, investors can come to their own conclusions on a share price by analysing the fundamentals. Measures such as the Price/Earnings ratio (PE ratio), Dividend Yield and Revenue are just a few of the important statistics to consider.

Finally it is important to consider that social psychology has an important role to play when sizing up investments. Share prices can be affected by a herd mentality. For short-term investors (traders), the fact alone that the price is going up (or down) is justification enough for buying the stock irrespective of other factors. The technical term for this is 'momentum buying' but for some unlucky investors it can be seen as little more than a pyramid scheme where the last one in will lose money. Momentum buying can very quickly turn into momentum selling, so please beware of jumping on the bandwagon too late.