How are the prices of stocks and bonds determined?

March 1, 2012  | By Kevin Smith

This is an extremely important question that requires a fundamental understanding of the relationships between companies and their investors and of risk and return. If you get a handle on these concepts, you will have a better idea for how investing works in general. I believe this should be taught in every high school.

Let’s keep it as simple as possible by looking at the two main groups that make investing possible.

The Parties

There are companies who want to raise funds to grow, compete and become more profitable, and there are investors with excess savings they want to make a return greater than what cash earns in their savings account.

These two parties have competing interest. Companies want to keep their costs of raising money as low as possible and investors want to get the highest possible return on their money. Companies and investors negotiate until they agree on the terms of a financial transaction that they are both happy with.

The Deal

Companies generally raise money from investors by 1) selling a portion of the company in the form of shares of stock, thus diluting the ownership of current shareholders or 2) borrowing money from investors in the form of bonds, for which they have to pay interest.

In the case of selling stock, the company wants their price per share to be as high as possible so they can raise as much money as possible by selling as few shares as possible. In the case of selling bonds, companies want to pay the lowest interest rate possible to investors to minimize their expenses and maximize their profits.

On the other side of the transaction, investors make money on stocks from dividends the company pays out of their profits and the potential increase in the stock price from the time of purchase to the time of sale. Investors are generally interested in earning high dividends and paying as low a price as possible for the stock to increase the benefit from future price increases. As it relates to bonds, investors want to earn the highest interest rate possible to maximize their return.

The Risk Factor

This is the dance performed by millions of buyers and sellers of stocks and bonds every day and the key ingredient to making it all work is evaluating RISK. Companies with higher risks of not providing a positive return will have to compensate their investors with a higher expected return by selling their stock at a lower price or agreeing to pay a higher interest rate on their bonds.

Ultimately, investors balance the possible rewards from investing against the possible risks of investing and adjust the price they are willing to pay for the stock up or down accordingly, and adjust the interest rate they require for loaning money accordingly.

To answer the question posed in the title of the blog, a company’s cost of raising money is approximately equal to the investor’s required return on that investment. An investor should expect a return on their investment equal to the issuing company’s cost of raising money. The higher the perceived risk in the investment, the higher the investor’s required return, the higher the company’s cost of capital, the lower the issued share price, the higher the issued interest rate, the less likely the investor is to actually achieve their required return.

A couple of examples…

If Home Depot and Lowes are identical companies except one is orange and the other is blue, their stock prices should be the same. If however, Home Depot suddenly faces a massive lawsuit for safety violations, investors will immediately perceive Home Depot as a riskier investment and lower the amount they are willing to pay for a share of Home Depot stock, pushing the price for a share of Home Depot downward. The investor has effectively increased his or her required return on the investment by lowering the current price such that if Home Depot recovers, the investor will earn a greater return on investment.

Consequently, Home Depot will have to sell more shares of stock to raise the same amount of money compared to when their share price was higher.

Let’s pretend that Dell has just sold $1 billion of bonds to investors paying 5% interest for 5 years. This means investors loaned Dell $1 billion in return for a commitment to receive 5% of their investment each year in interest and their full investment back at the end of the 5 years. On the other side of the coin, Dell now has a billion more dollars with an obligation to pay $50 million per year in interest for the next 5 years and send $1 billion back to those investors at the end of 5 years.

Now let’s pretend that China has increased taxes on foreign manufacturers in their country, which will raise Dell’s costs of production by 10%. This lowers the expected profitability of Dell, and therefore increases the risk that Dell will not be able to pay the interest on its bonds. If Dell decided to raise another $1 billion for expansion, investors would likely require a return greater than 5% to compensate for the additional risk of not being paid back, 7% for example. In that case, Dell would have to pay $70 million per year in interest to investors – a 40% increase in their cost of borrowing money!

In both cases, investors perceived more risk and required a greater return on their investments. In turn, the companies raising the money incurred additional costs, in the form of having to sell more shares of stock for Home Depot and making higher interest payments for Dell.

Again, a company’s cost of raising money is approximately equal to the investor’s required return on that investment. Increasing the number of companies and investors competing for investments and evaluating risks will generally increases the fairness of prices in a market.