How is the initial price set on the Stock Market?

30.JAN.09

Question: What does the price of a stock represent and when a company is first listed on the stock market who sets its initial price?

Answer: From a fundamental standpoint, the price of a stock represents the market value of that company on a per share basis and is also relative to the amount of dividends the company pays periodically.{{more}} Therefore, the total market value of the equity of that company is the product of the amount of shares outstanding by the price of one share.

In addition, according to theory, in an efficient market, all historic public information and expectations of the future performance of that company in terms of growth opportunities, and profitability are priced into the value of the particular stock.

When a stock is first listed on a Stock Exchange, as in an Initial Public Offering (IPO), the price it will eventually list at depends on many factors. Most companies, however, base the IPO price on multiples such as price/book and price/earnings of other companies in their peer group. This valuation is normally done by an independent, professional investment manager. Most IPOs are normally offered at a discount (or what is known as under-pricing), making them very attractive to investors.

Question: In stock market terms, what is a derivative?

Answer: A derivative is typically defined as an asset which derives its value from another asset. Derivatives are typically based

Options give the buyer the right but not the obligation to buy (a call option) or sell (a put option) a stock at a specified price (called the strike or exercise price) at some specified time in the future.

A premium or cash consideration is paid for the right to own the option and is based on many factors, including the strike price, and the difference between it and the current market price or what is called the intrinsic value of the option. Other major factors affecting the premium would be the time to expiration and the volatility of the underlying asset’s price. There are also options and future contracts on stock indices.

However, there is a wide variety of derivatives which can increase in complexity, including futures contracts, swaps and swaptions which are options on interest rate swaps and can be used as a risk management tool or for speculative purposes.

Question: What is meant by Cyclical Stock?

Answer: A cyclical stock is the stock of a company whose revenues/profits are sensitive to the level of business activity within the economy. For example, a company that sells luxury goods/services, e.g. yachts, travel etc., may have strong revenue growth in times of high business activity, i.e. when the economy is expanding, but will have declining revenues when the business cycle is trending downward, as in times of recession.

However, there are companies that do not do that well when the economy is growing rapidly. For instance, banks do well when the business cycle is coming off its peak as interest rates decline and there is greater demand for credit.

Stocks that do well when the business activity is decreasing and poorly when the economy is peaking are called counter-cyclical. Basic consumer goods companies/stocks are generally non-cyclical, given demand for these products is inelastic if they are not easily substitutable and are referred to as defensive stocks e.g. wheat, utilities etc.

All information contained in this article has been obtained from sources that CMMB believes to be accurate and reliable. All opinions and estimates constitute the Author’s judgment as of the date of the article. However, neither its accuracy and completeness nor the opinions based thereon are guaranteed. As such, no warranty, express or implied, as to the accuracy, timeliness or completeness of this article is given or made by CMMB in any form whatsoever.

CMMB and/or its employees or directors may, where applicable, make markets and effect transactions, or have positions in securities or companies mentioned herein. Neither the information nor any opinion expressed shall be construed to be, or constitute an offer or a solicitation to buy or sell.