What determines stock prices?

If the success of investing in stocks is not dependent on your trading method, what does matter? What are the other factors that determine the true price of a stock? In order to answer this question, you must first understand two basic principles.

The first principle lies in the phrase of Warren Buffett, the greatest value investor of all time: “In the short term, stocks behave like a slot machine, but in the long run, they behave like a weighing machine.” What this means is that in the short term (a short period of time is up to several years) the price of a share is driven randomly by the supply and demand for it. The publication of a positive report regarding the company’s activity may raise the share price up by many percentages, and canceling a contract with a major customer may lower its price sharply within a short period of time. Since these fluctuations are unpredictable, they cannot be used to gain money consistently in the long-term.

The second principle is derived from the fact that purchasing a share is equivalent to buying part of a company. Therefore, despite the randomness of the share price in the short term, its real price in the long term is derived from the company’s intrinsic value (also known as Fair Value), which is determined by the fundamental results of the business itself – the rate of growth, the amount of cash it generates, its moat, its management and more. In other words, the real value of the company at any given time is constant, and only the share price moves up and down around this value due to the short-term orders of traders who do not recognize the fact that in the long run the price will equal value, and the stock will trade at a price that reflects this fair value.

For most of the time, the stock market is efficient and prices most companies according to their true value. However, because the activity of companies is dynamic and because many investors ignore the financial results of the company and concentrate solely on the share price movements, there are many cases in which a share is traded temporarily at a price lower than its value. The success in stock investing lies in tracing these companies traded below the real value, buying their shares at a discount and waiting patiently until the market recognizes its mistake and raises the share price. Once the share price is equal to its value (or rises to a little higher), you should sell the stock and replace it by a new one that is currently traded at a discount. This is the practice of the most successful investors in the world, and this strategy is also the method we are using and is explained throughout this guide.

Read on to the next chapter: