Supply and Demand in the Short Run
In the immediate term, a share price is determined by the same mechanism that sets the price of anything traded in a market: supply and demand. If more investors want to buy a stock than sell it, the price rises until sellers are willing to part with their shares. If more want to sell than buy, the price falls until buyers are attracted.
This short-run mechanism can be driven by news, rumour, sentiment, earnings surprises, analyst upgrades, social media trends, or simply the momentum of recent price moves. It is noisy, reactive, and frequently has little to do with any rational assessment of a company's underlying value.
Discounted Future Earnings in the Long Run
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In the long run, something more fundamental governs prices. In 1938, American economist John Burr Williams published The Theory of Investment Value, in which he argued that the true value of any asset — stock, bond, or real estate — is the present value of all the cash flows it will ever produce, discounted back to today at an appropriate rate. This insight became the foundation of modern valuation theory.
Applied to equities, this means a share is worth the sum of all future dividends (or free cash flows) the company will generate, each divided by a discount factor that reflects both the time value of money and the risk of receiving them. A business generating reliable, growing cash flows for decades is worth a great deal more than one generating unpredictable, declining cash flows — even if both are the same size today.
The long-run price therefore depends on: (1) how much cash the business will generate; (2) how fast it will grow; and (3) how certain investors are that they will actually receive it. Changes in any of these three inputs move prices — sometimes dramatically.
Why Prices Deviate from Intrinsic Value
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If prices reflect discounted future earnings in the long run, why are they so volatile in the short run? The answer is that investors do not know the future. Estimates of future earnings, growth rates, and appropriate discount rates shift constantly as new information arrives. Beyond genuine uncertainty, prices also deviate because of emotion, leverage, liquidity constraints, and what John Maynard Keynes identified in his General Theory (1936) as the beauty contest problem.
The Keynes Beauty Contest
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Keynes described the stock market as resembling a newspaper beauty contest of his era, in which readers were asked to pick the six prettiest faces from a hundred photographs — but the winner was whoever picked the most popular faces, not their personal favourite. Rational participants, Keynes noted, would not vote for who they found most attractive, or even for who they thought most people would find attractive, but for what they thought most people would think most people would find attractive — reasoning about the reasoning of others, potentially several levels deep.
Applied to equity markets: a rational investor does not simply buy stocks they believe are undervalued. They buy stocks they believe other investors will come to recognise as undervalued — or that momentum will carry higher. This dynamic can cause prices to diverge substantially from intrinsic value for extended periods.
Market Microstructure
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At the mechanical level, prices are set through the interaction of bids and offers. A bid is the highest price a buyer is currently willing to pay; an ask (or offer) is the lowest price a seller will accept. The difference is the bid-ask spread, which represents the cost of transacting immediately. Highly liquid stocks — those with many buyers and sellers — have tight spreads. Illiquid stocks have wide spreads, making them costly to trade.
Market makers — firms that stand ready to buy or sell continuously — provide liquidity by quoting both a bid and an ask at all times. They profit from the spread while taking on the risk of holding inventory. Electronic markets and algorithmic traders have compressed spreads dramatically over the past two decades.