What is 'Price Discovery'

Price discovery to the overall process, whether explicit or inferred, of setting the spot price of an asset or service, but most commonly the proper price of a security, commodity, or currency based on many factors. These include supply and demand, intangible factors such as investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs.

BREAKING DOWN 'Price Discovery'

Basically, price discovery involves finding where supply and demand meet. In economics, the supply curve and the demand curve intersect at a single price, which then allows a transaction to occur. The shape of those curves is subject to many factors, from transaction size to background conditions of previous or future scarcity or abundance. Location, storage, transaction costs and buyer/seller psychology also play a role. There is no specific formula using all these factors as variables. Indeed, the formula is a dynamic process that can change frequently, if not from trade to trade.

Rather than consider price discovery to be a "thing" or a specific process, it should be considered the central function in any marketplace, whether it be a financial exchange or the local farmer's market. The market itself brings potential buyers and sellers together, with members of each side having very different reasons for trading and very different styles for doing so. By allowing all buyers and sellers to come together, these marketplaces allow all parties to interact and by doing so a consensus price is established. Without knowing it, all the players do it again to set the very next price, and so on. 

Those parties with the freshest or highest quality information can have an advantage as they can act before others get that information. When new information arrives, it changes both the current and future condition of the market and therefore can change the price at which both sides are willing to trade.

Price Discovery vs. Valuation

Price discovery is not the same as valuation. Where price discovery is a market driven mechanism, valuation is a model driven mechanism. Valuation is the present value of presumed cash flows, interest rates, competitive analysis, technological changes both in place and envisioned, and many other factors.

Other names for valuation of an asset are fair value and intrinsic value. By comparing market value to valuation, some analysts can determine if an asset is overpriced or underpriced by the market. Of course, the market price is the actual correct price, but any differences may provide trading opportunities if and when the market price adjusts to include any information in the valuation models not previously considered. 

 

RELATED TERMS
  1. Discovery Value Accounting

    Discovery value accounting was a former method of accounting ...
  2. Discovery Cover

    Discovery cover is an insurance policy that indemnifies the policyholder ...
  3. Asset Valuation

    Asset valuation is the process of determining the fair market ...
  4. Accounting Valuation

    Accounting valuation is the process of valuing a company's assets ...
  5. Comparable Company Analysis - CCA

    A comparable company analysis (CCA) is a process used to evaluate ...
  6. Relative Valuation Model

    A relative valuation model is a business valuation method that ...
Related Articles
  1. Investing

    Top Reasons IPO Valuations Miss The Mark (MS, ZNGA)

    The costly services of investment banks don’t necessarily guarantee accuracy in IPO pricing.
  2. Insights

    4 Factors That Shape Market Trends

    Discover the four major factors that shape market trends: Government, international transactions, speculation/expectation, and supply and demand. These areas are all linked as expected future ...
  3. Investing

    Relative Valuation: Using Stocks To Value Other Stocks

    This effective approach will help you understand which stocks you should be investing in.
  4. Managing Wealth

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  5. Investing

    How an IPO is valued

    The initial valuation of an IPO can determine the success or failure of a specific stock – but how is that price determined?
  6. Trading

    How to Build Valuation Models Like Black-Scholes

    Want to build a model like Black-Scholes? Here are the tips and guidelines.
  7. Investing

    How to choose the best stock valuation method

    There are many valuation methods available to investors, each with unique characteristics. Here, we'll explore the most common valuation methods – and when to use them.
RELATED FAQS
  1. How is market value determined in the real estate market?

    Learn how fair market value is determined during a real estate appraisal and how market values are really decided by professional ... Read Answer >>
  2. How is a company's stock price and market cap determined?

    A company's market cap is represented by its outstanding number of shares multiplied by its stock price, which is initially ... Read Answer >>
Trading Center