2.2.2 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Explain price discovery and news relative to expectations.
- Interpret liquidity, spreads and price impact.
- Separate a plausible price mechanism from a guaranteed prediction.
2.2 · Valuation
Define the cash flow
Valuation · the work you will do
- 1Define the cash flow
- 2Make assumptions explicit
- 3Estimate a range
- 4Compare with price
Before you begin
A company’s profit rises 10%, yet its share price falls after the announcement. How can both observations be consistent?
Write your first response before continuing.
Video coming soon · about 3 minutes
What Determines a Share Price?
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. A company’s profit rises 10%, yet its share price falls after the announcement. How can both observations be consistent? Take a first view. You can change it when you have considered the evidence.
A trade requires a buyer and seller agreeing terms. Orders, available supply and changing demand influence executable prices. Different participants have different horizons and information. Price discovery reflects their interaction; a classroom supply-demand diagram is a simplification, not a promise that one headline determines the next trade. Distinguish a quoted price from what a large order could actually achieve.
If investors expected 20% profit growth, a 10% increase can disappoint. Guidance, cash quality or financing needs may also change the interpretation. A smaller legal penalty than feared could improve expectations even though it is still a cost. Use phrases such as “could, all else equal” and name a countervailing factor. Exactly expected results do not guarantee an unchanged price when other information arrives.
A liquid market can absorb relevant orders relatively quickly without excessive price impact. The bid is a price at which someone may buy; the ask is a price at which someone may sell, subject to size and conditions. Spreads and depth matter. Liquidity can deteriorate in stress; a normally active listing is not a guarantee of immediate execution at an unchanged price.
Separate verified public evidence from rumours and privileged information. When uncertain about confidential information, stop the analysis based on it and seek appropriate guidance rather than use it as an advantage. In this course no real trading is required. A return above a benchmark is observed excess return on a stated basis; it does not alone prove persistent, risk-adjusted skill.
Let's work through A spread costs money before a forecast works. A hypothetical share is quoted bid £7.90 / ask £8.10 for the relevant small order. A pupil hypothetically buys 100 shares at the ask and immediately sells at the unchanged bid. Ignore all other costs. Pause here and try the calculation or reasoning before continuing.
Purchase cost = 100 × £8.10 = £810. Sale proceeds = 100 × £7.90 = £790. Loss = £20; loss relative to purchase cost = 20/810 = 2.469%, about 2.47%.
The quoted midpoint of £8 is not a guarantee that either trade can execute there. Large orders can incur further price impact.
Now try the choices in this lesson. If your answer changes, identify the reason. Separate a plausible price mechanism from a guaranteed prediction. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
Buyers and sellers meet
A trade requires a buyer and seller agreeing terms. Orders, available supply and changing demand influence executable prices. Different participants have different horizons and information. Price discovery reflects their interaction; a classroom supply-demand diagram is a simplification, not a promise that one headline determines the next trade. Distinguish a quoted price from what a large order could actually achieve.
Surprises matter
If investors expected 20% profit growth, a 10% increase can disappoint. Guidance, cash quality or financing needs may also change the interpretation. A smaller legal penalty than feared could improve expectations even though it is still a cost. Use phrases such as “could, all else equal” and name a countervailing factor. Exactly expected results do not guarantee an unchanged price when other information arrives.
Liquidity is conditional
A liquid market can absorb relevant orders relatively quickly without excessive price impact. The bid is a price at which someone may buy; the ask is a price at which someone may sell, subject to size and conditions. Spreads and depth matter. Liquidity can deteriorate in stress; a normally active listing is not a guarantee of immediate execution at an unchanged price.
Information and disciplined inference
Separate verified public evidence from rumours and privileged information. When uncertain about confidential information, stop the analysis based on it and seek appropriate guidance rather than use it as an advantage. In this course no real trading is required. A return above a benchmark is observed excess return on a stated basis; it does not alone prove persistent, risk-adjusted skill.
A spread costs money before a forecast works
A hypothetical share is quoted bid £7.90 / ask £8.10 for the relevant small order. A pupil hypothetically buys 100 shares at the ask and immediately sells at the unchanged bid. Ignore all other costs.
- Purchase cost = 100 × £8.10 = £810.
- Sale proceeds = 100 × £7.90 = £790.
- Loss = £20; loss relative to purchase cost = 20/810 = 2.469%, about 2.47%.
The quoted midpoint of £8 is not a guarantee that either trade can execute there. Large orders can incur further price impact.
Put it into practice
1. Reason through surprises
For profit of 110 versus an expected 120, and a penalty of 5 versus a feared 20, give a plausible price effect and one limitation for each.
Record your response in your workbook before opening feedback.
Compare with a model response
The profit disappointment could lower price; the smaller penalty could support it. Forward guidance, prior positioning, rates and wider news may change either outcome.
2. Compare liquidity
Compare a small listed-share order with selling a private warehouse. What must be known before labelling either easy to sell?
Record your response in your workbook before opening feedback.
Compare with a model response
Order or asset size, market depth, settlement, legal process, time available and price concession matter. The listing label alone does not fix achievable price or timing.
3. Write a market note
A share falls despite profit growth. Write two plausible explanations and the public evidence you would seek.
Record your response in your workbook before opening feedback.
Compare with a model response
Expectations may have been higher, or cash conversion/guidance may weaken. Check the release, outlook, consensus definitions and market context without claiming a single observed cause is proved.
Jargon buster
Price discovery
The process through which trades and information shape prices.
Expectation
What participants anticipated before new information.
Bid
A quoted buying price subject to size and conditions.
Ask
A quoted selling price subject to size and conditions.
Spread
The difference between ask and bid.
Price impact
The effect of an order on executable prices.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138 connections: 3.1.4 financial management, 3.3.3 strategy/investment appraisal, 3.3.4 change and uncertainty; Annex 6 quantitative interpretation; AO2–AO4 application, analysis and evaluation. Enterprise DCF, WACC, trading multiples and SOTP are investing enrichment, not prescribed AQA company-valuation methods.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Explain price discovery and news relative to expectations. Interpret liquidity, spreads and price impact. Separate a plausible price mechanism from a guaranteed prediction.