How does price discovery take place in the stock market?
Let us say a company makes Rs.1000/- as profit. Also, let us assume the company has 100 shares.
So, earnings per share (EPS) i.e., profit / no. of shares = Rs.1000 / 100 = 10.
Let us say the price per share in the market is Rs.100/-. Then the P/E would be Price of share / Earnings per share 100/10 = 10. Since P/E = 10, it means a buyer, Mr. Shyam is willing to pay 10 times the company’s annual earnings per share! This means that the buyer would take 10 years to recover his cost of buying.
However, 10 years seems a long time to recover his investment. So, what is his motivation for investing?
Let us say there is a surge in the demand for the company’s products causing its profits to go up from Rs.1,000.- to Rs.10,000/-!
Now what is interesting to observe is that while the profit went up from Rs.1000/- to Rs.10,000/- the number of shares remains the same at 100. Hence, by definition, earnings per share would be Rs.100/-.
Since Mr. Shyam invested Rs.100/- for a share, whose EPS has increased from Rs.10/- to Rs.100/-, he is now able to recover his investment within a year.
Assuming the P/E remains at was 10 and earnings per share has gone up to Rs.100/-, the price of the share would then be Rs.1000/-.
Hence, Mr. Shyam, who paid Rs.100/- per share could sell the same for Rs.1000/- and make a profit of Rs.900/-.
But the story does not end here.
When people see that a company, which was making Rs.10/- per share sometime back, is now making Rs.100/- per share, they all want to buy the shares of this company and thus the demand shoots up!
And this demand causes the P/E to go up from 10 to let us say 12.
When the P/E moves up from 10 to 12, the market price of the shares too moves up to Rs.1200/- from Rs.1000/-.
Now Mr. Shyam, who had initially bought a share for Rs.100/-, can now sell the same for Rs.1200/- and make a profit of Rs.1100/-!
Thus, we have seen how the price of a share is discovered in the market.
It is a function of both the earnings per share, which is the profitability of the company, as well as the sentiments and expectations of the market causing demand to rise, which increases the P/E ratio!