When companies go public for the first time – that is they hold their Initial Public Offering (IPO) – they sell new shares to investors. This is done on a market called the Primary Market. The proceeds from the sale result in cash infusion into the company.
The company’s shares are now available on the open market and can be bought and sold by anyone. This is the Secondary Market or the stock exchange as we know it.
When the company’s shares exchange hands on the stock exchange, the transaction is done between different investors and not with the company. Therefore, when shares are bought or sold on the stock market the company does not see any money come in or go out.
So, why do companies care about their stock price even after the IPO?
And what can happen to a company if its stock rises or drops?
Let’s find out.
Why do companies care about their stock price?
Here are the 7 reasons why companies care about their stock price:
- Proxy for Financial Health
- Ability to raise fresh funds
- Management Performance/Compensation
- Employee Compensation
- Build a moat against Hostile Takeovers
- Facilitate Acquisitions
- Grow Shareholder Value
Let’s look at each of these in some detail.
1. Proxy for Financial Health
When a company goes public, investors can buy and sell its shares on the open market.
The price of these shares will fluctuate every day based on changing demand-supply conditions in the stock market.
If a company shows strong financial health, more investors will want to buy its shares than those who want to sell them, and the stock price will go up.
Conversely, if a company shows poor financial health, more investors will want to sell shares than buy them and the stock price will go down.
This is why the stock price is often seen as a proxy of a company’s financial health.
2. Ability to raise fresh funds
From time-to-time companies need to raise fresh money to fund new investments, to re-finance existing investments, pay down debts, or cover operational expenses.
When a company decides to raise fresh funds by issuing new stock on the stock market, the price it can fetch for this new stock is directly linked to the price of its shares on the open market.
The higher the existing price, the more money it can raise for every new share issued.
Also, investors are more willing to invest in a company that is financially healthy and has strong prospects for the future.
The company’s stock price is also a good measure of how much confidence the market has in its ability to generate future profits and therefore on its ability to raise money for financing the future.
3. Management Performance/Compensation
The performance and compensation of the management of a publicly-traded company are almost always closely linked to the company’s stock price.
A high-performing management team will do its best to increase the stock price through better performance and by promoting long-term growth prospects of the business.
On the other hand, management that fails to deliver on expectations may see their job security diminish as the stock price falls.
In many companies, managers are rewarded by receiving a portion of their compensation in the form of company shares which is directly linked to how well the share performs on the open market.
This compensation structure forces management teams to focus on increasing shareholder value rather than focusing solely on their own short-term interests.
4. Employee Compensation
A company’s employees can also be compensated through stock grants or stock options.
Stocks and stock options are typically given to employees at no cost, and they usually vest over a period of time.
Employees who hold vested shares can benefit from any increase in the share price as they can sell these shares on the market at a profit.
Employers can use options as incentives or rewards for individual hard work but the payoff comes only if the company’s share price goes up. If the stock price falls, the options can go “underwater” – that means priced lower than the price at which they were granted to the employee – and so the employee will make no money by selling them.
Since employee compensation from stocks or stock options is linked to the stock’s market price, this creates a direct incentive for the employee to work to increase the company’s stock price.
A high stock price also signals that the business is doing something right which helps to attract quality employees who are then motivated by rewards linked to the company’s performance.
5. Build a moat against Hostile Takeovers
Another important reason why companies care about their stock price is that it can make hostile takeovers more difficult.
If a company has a high share price, another company will need to fork out much more money to buy the target company’s shares on the open market.
So, a high stock price can make a company less vulnerable to takeover bids from competitors or even short-term investors looking for an easy target. This gives the company more stability and makes it less likely to be forced into a sale against its will.
This is especially important for businesses that are in industries where there is a lot of consolidation, such as telecoms or energy.
In these sectors, the biggest players tend to gobble up all the smaller ones, so if a company isn’t among the top few players, it’s at risk of being bought and absorbed or dismantled. A high stock price can help shield such a company from these kinds of unwanted advances.
6. Facilitate Acquisitions
When a company has a high stock price, it generally means that the market is happy with the direction of the business and its prospects for future growth.
This makes it easier for the company to borrow money to finance an acquisition, as lenders will be more confident in the company’s ability to repay the loan.
A company’s stock can also be used as currency. A company could issue new stock and use it to pay for an acquisition – as in a stock-swap deal. The company’s stock can also be offered as compensation to key employees of the acquired company which the acquiring company wishes to retain.
7. Grow shareholder value
Increasing shareholder value is one of the key objectives of the management of a publicly-traded company. And shareholder value is directly linked to the stock price.
After all, shareholders are the owners of the company. And the management works for the owners. So, it makes sense that the owners task their employees, the management, to grow the value of their investment.
Often the stock price is a leading indicator of a company’s performance. It is a barometer of how the market perceives its growth prospects. A high share price signals that the market expects the business to be more valuable in the coming years, either by increasing earnings or buying back shares.
Most investors purchase stock with the expectation that it will go up over time.
Therefore, corporate executives try to improve their firms’ performance by focusing on growing revenue, reducing costs, increasing profits, and ultimately improving key metrics like the earnings per share (EPS).
How does a company benefit when its stock price increases?
When a company’s stock price increases, it typically means that more investors are interested in buying the company’s shares than selling them. So, demand is greater than supply.
An increasing stock price is a reflection that the market feels that the company is in good financial health and has a bright future. This can make it easier for the company to raise financing, hire the best employees and compensate them using stocks and shares instead of entirely with cash.
An increasing stock price also acts as a moat against takeovers and makes it easier to attract other companies which wish to be acquired.
What happens to a company when its stock falls?
When a company’s stock falls, it typically means that more investors are selling the company’s shares than buying them. So, supply is outstripping demand.
A falling stock price makes it harder for a company to raise money from equity markets because it’s an indication that the market is skeptical about the company’s future.
Companies with falling stock prices often have to look for other sources of financing, such as issuing debt or taking out loans from banks.
When a company’s share price is on a downward trend, potential investors may be reluctant to buy them because they may believe that the stock still has further to fall and that they will lose money if they purchase them at that point. They may even sell the shares they already own, putting even more pressure on the stock price.
A falling stock price can also lead to lower employee morale and make these employees perfect targets to be poached by competitors.
A low stock price also makes the company vulnerable to takeovers and makes it harder for the company to grow through acquisitions.
Finally, a falling stock price with a company headed in the wrong direction can be a cause for a shareholder revolt which could vote the current management out and bring in a new management team to lead the company in a new direction.
Summary
All publicly-traded companies care about their stock price.
The reasons why they care differ from company to company.
The stock price is considered a proxy for the financial health and future prospects of a company and therefore also as a reflection of the performance of the company’s management and board of directors.
Other reasons why companies care about their stock price are that strong stock prices make it easier to raise money, compensate managers and employees, protect the company from becoming a takeover target, facilitate growth through acquisitions and grow shareholder value.
