How the stock market works
Novice investors often approach the stock market with trepidation, but the market is simply a forum that brings together investors who want to buy and sell part-ownership stakes in companies, known as stocks or shares.
As we have discussed in previous entries in this series, investing in shares offers you the potential to grow your money at a quicker pace than would be possible if you squirrelled cash away in a bank account and in return for a paltry rate of interest.
In order to trade with other buyers and sellers, you will first need to open a dealing account or an individual savings account (ISA) with a stockbroker, whose platform will connect you with other traders.
For many decades, the London Stock Exchange (LSE) provided a trading floor where members could buy and sell shares. Today, share trading is almost entirely done electronically and the LSE offers this service with state-of-the-art systems that can process over a million trades per day.
Stock market opening times reflect the geographic location of each local exchange.
WHAT IS AN AUCTION?
Different to regular trading on an exchange, auctions are used in many markets around the world to open and close stock markets and as well as a way to re-start the market if a stock has been halted due to a ‘volatility interruption’, which in plain English means a wild share price move up or down.
The opening of the market is preceded by an opening auction. This sets the opening price in a SETS security; the opening auction ‘call period’ is where orders are collected from the market. This starts at 7.50am and ends just ten minutes later at 8am.
During the opening auction, stockbrokers can enter certain types of orders for execution during what’s known as an ‘uncrossing’, basically a process where orders that can be matched between buyers and sellers are executed. The trading day ends with a similar auction pre-4.30pm and, as discussed, auctions can occur during the trading day, triggered by substantial price swings in a security.
WHAT DETERMINES A SHARE PRICE?
Numerous factors influence a share price, among them investor sentiment towards the sector or industry a company is in, but the main factor is how well said business is performing.
When a firm is doing well investors want to own it, so demand pushes the share price higher, and vice versa. Share prices reflect the market’s view of the prospects for a company and its earnings and cash flows, as well as the tone and detail of recent news announcements.
Positive trading updates and forecast-beating financials typically drive upgrades to earnings estimates and a re-rating of the multiple investors are prepared to pay for a stock.
In contrast, downbeat updates and profit warnings trigger downgrades and de-ratings of a stock and its earnings multiple. Over-supply of a stock following the issue of new shares, which dilutes equity ownership, can also exert downwards pressure on a share price.
Salient examples in today’s market include Elon Musk-steered electric vehicle maker Tesla, whose shares have surged ahead amid frenzied buying in the belief the company will come to dominate the electric vehicle market.
Retailer Marks & Spencer’s (MKS) shares remain in the doldrums with investors anticipating a bleak future for the heavy challenged shopping chain amid seismic shifts in the retail sector.
PRICE ISN’T THE SAME AS VALUATION
One classic mistake many novices make is to confuse a low share price with a low or cheap valuation. You cannot judge whether a share is cheap by its share price alone. Let’s say you want to invest in the sportswear retail industry, where there are three competing companies listed on the stock market: Trainers PLC, The Snazzy Tracksuit Company and Bobby’s Sporting Goods. Their shares are priced at 50p, £4.50 and £10 respectively, so obviously Trainers PLC is the bargain selection, right?
Wrong! Bobby’s Sporting Goods trades on a forward price-to-earnings ratio of just seven times, despite the nominally higher share price, versus a 12 times multiple for The Snazzy Tracksuit Company and 18 times for Trainers PLC, an online-only retailer whose shares are in vogue with the market as it is delivering rapid earnings growth.
That said, Bobby’s Sporting Goods has lots of debt on its balance sheet, which is risky, while many of its brick and mortar stores are underperforming and its earnings are in decline, so it may not be the bargain pick. Its shares may well be cheap for a reason.
How many shares can I buy?
Investors should not get hung up on a company’s share price in isolation. It really doesn’t matter if you own 10 shares at 10p or one share at 100p. However, some share prices are high enough that it would make a difference if you wanted to invest a smaller lump sum or to drip feed a modest amount into the market at regular intervals. Let’s assume Marcus, a 35-year-old quantity surveyor, wanted to put £75 per month into perhaps one or two individual stocks. Even a single share in the likes of pharma giant AstraZeneca (AZN), consumer goods firm Reckitt Benckiser (RB.) and engineering giant Spirax-Sacro Engineering (SPX) would all be out of his price range at August 2020 prices.