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Why Is There a Difference Between Theoretical Price & the Current Stock Quote?

Original post by Slav Fedorov of Demand Media

Some investors like to compare a current stock price with how much they think a stock is worth to determine whether a stock is a good investment at current levels. This approach is based on the assumption that a stock represents a specific business that has intrinsic value, and that the market price may deviate from that value, but eventually comes back to reflect it.

Stock Valuation

Some stock analysts develop sophisticated formulas to determine how much a stock should be worth based on multiple factors, such as sales and earnings growth, cash flows or price-to-earnings ratios. Different valuation methods and methodologies can produce different results. A stock can have several theoretical prices, but can have only one market price, which is reflected in the current stock quote.

Stock Trading and Current Market Price

Buying and selling impacts the current stock price. When selling is stronger than buying, the stock price declines, and when buying is stronger than selling, the stock prices increases. Investors buy and sell for a variety of reasons, which may have little to do with stock valuation -- manipulation, short-term speculation or the need to raise cash. A stock price can change much faster than a company's theoretical stock valuation, which is based on numbers that do not change often.

Stock Price Trends

Stock prices move in trends. Once a major trend develops, it may last several months or quarters. Investors are influenced by changing stock prices more than by a theoretical valuation method. A rising stock price attracts more buyers who are willing to pay progressively higher prices for fear of "missing the train." Even if a stock price is initially equal to the theoretical valuation, a rising trend will push that price away from the valuation.

Market Valuation

Some believe that a stock is worth what investors are willing to pay for it at any given moment, so any theoretical valuation is irrelevant -- it is simply somebody's opinion of what a stock is worth. A stock price reflects what investors do, not what they think, and represents the opinions of all market participants, not just one.

                   

References

  • "A Random Walk Down Wall Street"; Burton G. Malkiel; 2007
  • "One Up on Wall Street"; Peter Lynch; 2000
  • "How to Trade in Stocks"; Jesse Livermore; 2001

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.

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