# Price Discovery Explained: Process, Factors, and Comparison with Valuation

## What Is Price Discovery?

Price discovery happens when buyers and sellers come together to agree on an asset price. It happens by considering factors like [supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp), risk, and economic conditions. This process is central to the market and trading, and is based on the point where supply and demand meet. Unlike valuation, which uses models to estimate worth, price discovery reflects the actual price agreed upon in the market.

### Key Takeaways

*   Price discovery is the process in marketplaces where buyers and sellers interact to agree on a price for a security, commodity, or currency, influenced by factors like supply and demand, market structure, and the economic environment.  
    
*   The law of supply and demand plays a critical role in price discovery, determining the balance between buyers and sellers that leads to the establishment of market prices.  
    
*   Unlike valuation, which is a model-driven mechanism based on projected cash flows and factors such as interest rates, price discovery is an interactive and dynamic process that can change frequently based on new market information.  
    
*   Transparency is essential in price discovery, as knowing the prices offered by others is necessary for establishing fair trade prices, similar to an auction process.

### The Law of Supply and Demand

The balance between buyers and sellers is a key factor in price discovery. The law of supply and demand is the main factor driving price.

## How Price Discovery Functions in the Market

At its core, price discovery involves finding where supply and demand meet.

In economics terms, the [supply curve](https://www.investopedia.com/terms/s/supply-curve.asp) and the [demand curve](https://www.investopedia.com/terms/d/demand-curve.asp) intersect at a single price, which then allows a transaction to occur. The shape of those curves is subject to many factors, from the size of the transaction to background conditions of previous or future scarcity or abundance. Location, storage, [transaction costs](https://www.investopedia.com/terms/t/transactioncosts.asp), and psychology also play a role.

There is no specific formula using all these factors as variables. Indeed, the formula is a dynamic process that can change frequently, if not from trade to trade.

### Evolution of Price Discovery Through the Ages 

Though the term is new, price discovery has existed for thousands of years. Ancient markets in the Middle East, Europe, India, and China brought together traders and buyers to agree on prices.

Today, derivatives traders at the Chicago Mercantile Exchange (CME) use hand signals and spoken cues to set commodity prices.

Electronic trading has mostly replaced manual processes, with mixed outcomes. While it has significantly increased trading volumes and liquidity, electronic trading has also resulted in more volatility and less transparency about large positions.

## The Intricacies of the Price Discovery Process 

Price discovery is the central function in any marketplace, whether it is a financial [exchange](https://www.investopedia.com/terms/e/exchange.asp) or a local farmer's market. The market brings potential buyers and [sellers](https://www.investopedia.com/terms/s/seller.asp) together, with members of each side having very different reasons for trading and varying styles for doing so.

By bringing buyers and sellers together, marketplaces allow the interested parties to interact, and by doing so a consensus price is established. Whether they're consciously aware of it or not, all the players do it again to set the very next price, and so on. 

Many factors influence price discovery, like market development, structure, security type, and available market information.

Those with the latest or best information have an advantage because they can act far quicker than others. When new information arrives, it changes both the current and future condition of the [market](https://www.investopedia.com/terms/m/market.asp) for that asset and therefore can change the price at which both sides are willing to trade.

Too much transparency in information can be detrimental to a market because it increases the risks for traders moving large or significant positions.

## Comparing Price Discovery and Valuation

Price discovery is not the same as [valuation](https://www.investopedia.com/terms/v/valuation.asp). Price discovery is a market-driven interactive process, while valuation is a model-driven mechanism. Valuation is the [present value](https://www.investopedia.com/terms/p/presentvalue.asp) of presumed [cash flows](https://www.investopedia.com/terms/c/cashflow.asp) of an asset, based on many factors including interest rates, competitive analysis, and technological changes both in place and envisioned.

Other names for valuation of an asset are [fair value](https://www.investopedia.com/terms/f/fairvalue.asp) and [intrinsic value](https://www.investopedia.com/terms/i/intrinsicvalue.asp). By comparing market value to valuation, analysts can conclude whether an asset is overpriced or underpriced by the market.

The [market price](https://www.investopedia.com/terms/m/market-price.asp) is considered the correct price, but any differences can provide trading opportunities if and when the market price adjusts to include any information in the valuation models not previously considered.

## Is Price Discovery a Transparent Process?

Price discovery has to be transparent in order to work correctly for both buyers and sellers. Consider the traditional auction process. If a bidder did not know what prices were being offered by other buyers, it would be impossible to establish a fair price for any participant.

## Which Comes First: Price Discovery or Valuation?

Valuation comes first. A buyer or seller determines an acceptable price, or price range, for an asset based on many factors. In fundamental stock analysis, for example, this includes looking at a company's earnings history, its competition, its management, and the product plans it has in the pipeline. That gives the buyer a way to project a stock's potential growth and set a fair price or price range for it. The buyer only then is ready to enter the interactive process of price discovery.

## How Do I Use Price Discovery When I Use an Online Broker?

Whether you're aware of it or not, you're using price discovery every time you buy or sell a stock or other asset. The current quote is either acceptable or unacceptable to you as a buyer or seller. If it's unacceptable, you wait until it changes.

## The Bottom Line

Price discovery refers to how buyers and sellers agree on a price for an asset. This makes trading possible. Price discovery is influenced by factors like supply and demand, market structure, liquidity, and available information. Unlike valuation, which uses models to estimate worth, price discovery reflects the actual market price. It depends on clear information and can be affected by economic conditions, investor behavior, transaction costs, and global events. Over time, it has evolved from traditional markets to modern electronic trading systems.

> **Article Sources**
>
> 1.  IG. "[What is price discovery and how does it work?](https://www.ig.com/us/trading-strategies/what-is-price-discovery-and-how-does-it-work--190605)"