Why should a company care about its stock price?

I received a fan mail (!) recently. It’s pretty rare for me to receive an e-mail that is not filled with insults death threats, so I think it’s worth reposting and discussing it here, especially given the interesting question it contains:

Hey Fs, great website, huge fan!

I’ve started studying finance during my free time and one thing I never got is why a company should care about its stock price. As far as I understand it, it doesn’t affect my business one bit. As long as the company works well and money is coming in, I fail to see the relevance of the stock price and the direction it takes. If the stock goes down, it sucks for the shareholders, of course, but that’s not my problem, is it?

Let’s say for example I’m the CEO of ABC inc and that my company trades at $100 per share. Let’s say someone comes out with a scathing report and crashes the stock back to $10. Why should I give a damn about it? What is it going to change for me?

Thanks,

Dan B.

Hey Dan B., thanks for the question.

Up to a certain point, you are perfectly right. Before I jump into the pith of your question, let me get the three following points out of the way, which are key to understand your question:

  1. Just to clarify, the stock price in general is irrelevant: it’s the market cap that matters. Owning 100 shares valued at $100 is exactly the same as owning 1,000 shares valued at $10. Hence, your question would be better formulated as “why should a CEO care about the market capitalization of his company” or perhaps “why should a CEO cares if its stocks is going down.” Obviously, a crashing stock price will lead to a lower market cap, but always remember that a company could simply sell more shares, or do a split, and artificially “deflate” the stock price.
  2. That being said, almost all CEOs, but also CFO, CTO, directors, managers and key employees receive stock-based compensation. Typically, this means stock option (calls). For instance, let’s say you are the CEO of ABC inc and the stock is at $100. I grant you the right to buy 1,000 shares at $150 per share. Of course, you wouldn’t use that right now (you could buy the stock for $100 on the market instead of $150), but let’s say the stock rises to $200; in that case, you could use your rights to buy 1,000 shares at $150 and immediately resell then at $200, making a ($200-$150)*1,000=$50,000. In other words, you will receive compensation based on how the stock fares over a certain period.
  3. A stock that crashed by a significant amount opens the door to a predatory takeover attempt, i.e. say your company goes from $10B in value to $1B. A competitor could very well make an offer to buy the company for $2B. Since your company is public, if shareholders accept the buyout offer, your company would be “bought out” by your competitor and you would “lose” your company. Even notwithstanding that kind of cheap attack, a competitor could attempt to grab 50%+1 of your shares (for slightly over $500M), thus end up controlling your company. Even controlling 10% of the stocks would give them significant leverage on your company. Other forms of acquisition/attacks also exist. A large market value is one such defense against nasty business tactics like that.
  4. Market capitlization is used for several financial reasons, from reserve ratios (i.e. how much money the company has to keep in cash) to interest rates on debts. Several instruments are based largely on the market cap; for instance, if a company is worth less than $1B, it could lose access to some markets and financial instruments.  Yes, this does imply you can in theory “crash” your computer and shove him out of some key markets. Say for instance you are a REIT: you are allowed to borring up to 50% of your market cap. If your market cap goes down, then so does your borrowing capability.
  5. In the business world, credibility is everything: a business worth $10B is quite simply far more credible than a company valued at $10M. Being reduced to a pile of rubble could imply losing contracts as some customers will be scared you might go bankrupt. Even if that fear is totally unfounded, in business, it’s often appearances first, facts seconds.
  6. Some investors might dump your stock simply because it drops below a certain market cap. Some people refuse to invest in any company valued at under $10B, for instance. Falling below that amount might force those people to sell. While this is a completely stupid approach to investing in general, you can’t argue against stupidity.
  7. In theory, if the stock really doesn’t perform well at all, shareholders could grow tired, vote you out at a special meeting and replace you with anyone they choose. You could thus lose your job.
  8. High stock prices allow you to sell more shares to raise capital if needed. This adds flexibility to your balance sheet.

With that in mind, let’s approach the main element of your question as most of the elements above are rather extreme. Say you are the CEO of a company valued at $200B. Let’s say you are a good CEO and profits are steadily growing; your balance sheet is solid, you have great employees working for you, you don’t care about your stock options, no competitor is trying to wipe you out, you have stable contracts and you won’t need to raise money anytime soon, if ever. Given those facts, why should you care about it going to $175B, $225B, $150B or even $125B? Although rather large swings in magnitude, they are unlikely to affect your business in any way or shape, so why should you care?

Well you shouldn’t

The most important thing to understand about stocks prices is that they rarely follow logic. They rise for little to no reasons and they crash for little to no reasons. GoPro was once valued at $100 per share (lol) and ShakeShack opened on its IPO date at 1/12th of the value of McDonald’s, despite having less than 1/1,000th of the stores. Just three years ago, Apple was trading at a post-cash P/E ratio of 7 and during the financial crisis, some Canadian banks ended up with stock prices so low they were paying a 12% dividend that was well-covered by earnings.

Whenever you study finance, you understand that it takes very little to crash or hype a stock. This idiot from Citron Research managed to crash Valeant’s market capitlization by half with nothing but conjectures, suppositions and outright bullshit. And just look at the dotcom bubble if you need an example of the opposite.

Based on all that, caring about the price of a stock is a totally dilatory act. You simply can’t know when the latest rumor / report / conference / research paper / analyst opinion will either prop your stock or crash it. In my mind, a CEO shouldn’t even look at the stock price, for it may lead him to take poor decision. Say for instance the CEO is convinced he should do A instead of B. Now, the moment he tells the market about his choice, the stock crashes. He might be tempted to rethink his decision simply based on how the market reacted.

Of course, crashing stock prices are frustrating for shareholders, and since a CEO often owns shares of his company, it’s frustrating for him as well, but such is the nature of the game. Stocks go up for no reason and stocks go down for no reason. There is little you can do about it, except doing a share buyback or perhaps (in some cases), paying a dividend or increasing it.

With that in mind, there is a limit to how far the game of manipulation can go

Although a stock price can be manipulated either way, there are limits to what those fuckers (!) can do. Say for instance a company has $100B in cash and no debts. Say that company is valued at $50B. What can it do? Well, it could very well use its money to “buy itself out” and say “bye bye” to shareholders! Thus, it follows that a stock price can never fall below its cash value, for instance.

Similarly, say a low-risk company is earning $100M a year in profits, growing at 10% per year for the foreseeable future. Would a market cap of $300M make sense for this company? Obviously not since within 3 years, the company will have generated its entire market cap in profits only. If you saw such a company valued at such a low price, you would have to seriously re-evaluate your assumption that the company is low-risk because this is nothing short of the bargain of the century.

When a stock crashes so much even while your business is doing great, eventually, someone realizes it and it bounces back.

Now, let’s go back to your example of being the CEO of ABC Inc. Let’s say the market cap crashes by 90%, from a stock price of $100 to $10. If the company is working well and if you are still able to do business normally, then the stock price movement is entirely irrelevant. One would like to think such draconian moves don’t happen for no reasons, of course, but assuming nothing change, then as a CEO, nothing should change in your attitude neither. If anything, you should seriously consider doing a share buyback which will eventually benefit your company (more on that later). Eventually, the stock will go up and, if you managed your business correctly, higher than it was before the crash.

Hope that answers your question, Dan.

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