Generally speaking, the stock market is driven by supply and demand, much like any market. When a stock is sold, a buyer and seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When a second share is sold, this price becomes the newest market price, etc.
The more demand for a stock, the higher it drives the price and vice versa. The more supply of a stock, the lower it drives the price and vice versa. So while in theory, a stock's initial public offering (IPO) is at a price equal to the value of its expected future dividend payments, the stock's price fluctuates based on supply and demand. Many market forces contribute to supply and demand, and thus to a company's stock price.
Company Value and Company Share Price
Understanding the law of supply and demand is easy; understanding demand can be hard. The price movement of a stock indicates what investors feel a company is worth—but how do they determine what it's worth? One factor, certainly, is its current earnings: how much profit it makes. But investors often look beyond the numbers. That is to say, the price of a stock doesn't only reflect a company's current value—it also reflects the prospects for a company, the growth that investors expect of it in the future.
Predicting a Company's Share Price
There are quantitative techniques and formulas used to predict the price of a company's shares. Called dividend discount models (DDMs), they are based on the concept that a stock's current price equals the sum total of all its future dividend payments when discounted back to their present value. By determining a company's share by the sum total of its expected future dividends, dividend discount models use the theory of the time value of money (TVM).
The Gordon Growth Model
Several different types of dividend discount models exist. One of the most popular, due to its straightforwardness, is the Gordon growth model. Developed in the 1960s by U.S. economist Myron Gordon, the equation for the Gordon growth model is represented by the following:
Present value of stock = (dividend per share) / (discount rate - growth rate)
Or, as an equation:
- P is the current stock price
- g is the constant growth rate in perpetuity expected for the dividends
- r is the constant cost of equity capital for that company (or rate of return)
- D1 is the value of the next year's dividends
Example of a Share Price Valuation
For example, say Alphabet Inc. stock is trading at $100 per share. This company requires a 5% minimum rate of return (r) and currently pays a $2 dividend per share (D1), which is expected to increase by 3% annually (g).
The intrinsic value (p) of the stock is calculated as: $2 / (0.05 - 0.03) = $100.
According to the Gordon Growth Model, the shares are correctly valued at their intrinsic level. If they were trading at, say $125 per share, they'd be overvalued by 25%; if they were trading at $90, they'd be undervalued by $10 (and a buying opportunity to value investors who seek out such stocks).
The Bottom Line
The Gordon Growth Model equation above treats a stock's present value similarly to perpetuity, which refers to a constant stream of identical cash flows for an infinite amount of time with no end date. Of course, in real life, companies may not maintain the same growth rate year after year, and their stock dividends may not increase at a constant rate.
Also, while a stock price is conceptually determined by its expected future dividends, many companies do not distribute dividends.