Why Do Companies Care About Their Stock Prices?

Here's the irony of the situation: Companies live and die by their stock price, yet for the most part they don't actively participate in trading their shares within the market. Companies receive money from the securities market only when they first sell a security to the public in the primary market, which is commonly referred to as an initial public offering(IPO).

In the subsequent trading of these shares on the secondary market (what most refer to as "the stock market"), it is the regular investors buying and selling the stock who benefit from any appreciation in stock price. Fluctuating prices are translated into gains or losses for these investors as they shift stock ownership. Individual traders receive the full capital gain or loss after transaction costs and taxes.

The original company that issues the stock does not participate in any profits or losses resulting from these transactions, because this company has no vested monetary interest. This is what confuses many people. Why then does a company, or more specifically its management, care about a stock's performance in the secondary market when this company has already received its money in the IPO? Read on to find out.

Those in Management are Often Shareholders Too

The first and most obvious reason why those in management care about the stock market is that they typically have a monetary interest in the company. It's not unusual for a public company's founder to own a significant number of outstanding shares, and it's also not unusual for the company's management to have salary incentives or stock options tied to the company's stock prices. For these two reasons, managers act as stockholders and thus pay attention to their stock price.

Wrath of the Shareholders

Too often, investors forget that stock means ownership. Management's job is to produce gains for the shareholders. Although a manager has little or no control of share price in the short run, poor stock performance could, over the long run, be attributed to company mismanagement. If the stock price consistently underperforms shareholders' expectations, the shareholders will be unhappy with management and look for changes. In extreme cases, shareholders can band together and try to oust current management in a proxy fight. To what extent shareholders can control management is debatable. Nevertheless, executives must always factor in shareholders' desires since these shareholders are part owners of the company.

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Financing

Another main role of the stock market is to act as a barometer for financial health. Analysts are constantly scrutinizing companies, and this information affects the companies' traded securities. Because of this, creditors tend to look favorably upon companies whose shares are performing strongly. This preferential treatment is in part due to the tie between a company's earnings and its share price. Over the long term, strong earnings are a good indication that the company will be able to meet debt requirements. As a result, the company will receive cheaper financing through a lower interest rate, which in turn increases the amount of value returned from a capital project.

Alternatively, favorable market performance is useful for a company seeking additional equity financing. If there is demand, a company can always sell more shares to the public to raise money. Essentially this is like printing money, and it isn't bad for the company as long as it doesn't dilute its existing share base too much, in which case issuing more shares can have horrible consequences for existing shareholders.

The Hunters and the Hunted

Unlike private companies, publicly traded companies stand vulnerable to takeover by another company if they allow their share price to decline substantially. This exposure is a result of the nature of ownership in the company. Private companies are usually managed by the owners themselves, and the shares are closely held. If private owners don't want to sell, the company cannot be taken over. Publicly traded companies, on the other hand, have shares distributed over a large base of owners who can easily sell at any time. To accumulate shares for the purpose of takeover, potential bidders are better able to make offers to shareholders when they are trading at lower prices. For this reason, companies would want their stock price to remain relatively stable, so that they remain strong and deter interested corporations from taking them over.

On the other side of the takeover equation, a company with a hot stock has a great advantage when looking to buy other companies. Instead of having to buy with cash, a company will simply issue more shares to fund the takeover. In strong markets this is extremely common - so much that a strong stock price is a matter of survival in competitive industries.

Ego

Finally, a company may aim to increase share simply to increase its prestige and exposure to the public. Managers are human too, and like anybody they are always thinking ahead to their next job. The larger a company's market capitalization, the more analyst coverage the company will receive. Essentially, analyst coverage is a form of free publicity and allows both senior managers and the company itself to introduce themselves to a wider audience.

The Bottom Line

For these reasons, a company's stock price is a matter of concern. If performance of its stock is ignored, the life of the company and its management may be threatened with adverse consequences, such as the unhappiness of individual investors and future difficulties in raising capital.