How are stock prices determined?

The stock price of a company is an indication of the company's worth. It is essentially the value traders ascribe to the stock based on the information and expectation they have about its current performance and future prospects. A high debt to equity ratio indicates that a larger portion of a company's assets is funded by debt as opposed to equity, i.e, the company is highly leveraged, making them more open to the risk of insolvency should earnings be insufficient to pay back debt.

Naturally, the most basic determinant of the price of a stock is demand and supply. Due to non-stop trading in the stock market, the price of stocks is always changing. However, when new information about a company is released that affects or would affect it's profitability, you see a sharp rise or fall in the price of said company's stock. Unless new important information has been released however, you can expect a smooth, continuous rise and fall in the company's stock price in times when there is no market turmoil.

Profitability of the company is an obvious determinant of stock price. Apart from being reflected in the financial statements, profitability is further reflected in dividend payout. To give an understanding of the relationship between profitability and dividend, Mathematically, stock price is calculated as the present value of all future expected dividend payments. The more profitable a company is, the more likely it is that they would be able to distribute dividend to shareholders and stock prices are expected to positively react. The bottom line here is that companies are not obligated to pay dividends, and the decision to pay or not is a good indicator of management's future expectations for the organization.

Side bar: You might be wondering why companies bother paying dividends if they don't have to. Dividend payment is not a responsibility at any point in time (unless declared), but it should be paid from time to time to indicate that the company is doing well financially. Firms also pay dividends to make their stocks more attractive to potential buyers.

Since stock price is the current value of all future expected dividend payments, a rise in net income indicates a potential rise in dividends, and therefore, a rise in stock price. An increase in the profitability of the company however, is better understood by disregarding the mathematics of stock price determination and considering the fact that higher profitability means the equity of a company will be valued more. This is not just a one quarter or one period increase in income and so it means the prospects of earnings is even higher. With the higher valuation, stock price will increase as a result of the increase in demand for that company's stock.

One last important determinant of stock price is interest rate. Corporations use either bond (debt) or stocks to fund expansion. Increase in interest rate means the cost of borrowing has increased, making stocks the preferred way to fund expansion. That means, instead of issuing corporate bonds, the firm issues new shares which leads to dilution. This would reduce share price as there is now more shares within which earnings would be distributed.