As part of an initial public offering (IPO), a company sells shares to investors on the primary market. The stocks are then traded on the secondary market (stock exchange) between retail and institutional investors.
A company won’t make additional money directly if its stock price goes up on the secondary market, and it also won’t lose money if it goes down. With that in mind, does a company even care about its stock price? After all, it already made its money by selling the shares on the primary market during the IPO.
This is a common question asked by those new to the investing world and has a straightforward answer — yes, companies care a lot about their stock prices. Here are the five main reasons why.
Reason 1: Compensation
A company’s management often gets compensated with shares, which serve as a great motivator. There are different ways companies offer shares to their employees, one of them being in the form of employee stock options (ESO). Employees get the right to buy stocks at a set price for a specified period, which basically means they can get them at a discount if the company performs well.
To keep things simple, we won’t go into detail about how all of this works. What matters here is this: If you get compensated with shares of a company you work for, you’ll do your best to make sure the company is as successful as possible. Higher revenue and profits almost always translate to higher stock prices, which means that managers and other employees will earn more when they sell the stocks they own.
To give you an idea of how much executives can make with stocks, let’s take Apple’s CEO Tim Cook as an example. Cook cared a lot about Apple’s stock price since his performance bonus was tied to it. Because Apple’s stock achieved a higher return than two-thirds of other companies in the S&P 500, Cook received 5 million shares of Apple last year worth approximately $750 million — read more here.
Reason 2: Raising additional capital
A company can raise additional capital by selling new shares. The amount it can charge per share is directly linked to the current share price. So the higher it is, the more money a company can raise with the number of shares it plans on selling.
Companies have to be careful not to sell too many shares, as that increases supply and can cause the share price to drop if there isn’t enough demand from investors.
Additionally, a company that is growing and has proven to be a great investment can find new investors a lot easier than a company whose stock has dropped by 50% since the IPO. The only reason investors buy shares of a company is because they believe the company will continue to grow, which will cause the stock price to go up in the future.
Reason 3: Great press
A company whose market cap is constantly going up receives a lot of positive attention from the media, investors, as well as consumers. A rising stock price means that a company is doing something right. It means that it’s a winner — and everyone loves a winner.
Just look at Apple, for example. All the major media reported when Apple became the first company to reach a $3 trillion market cap, which brought a lot of positive exposure to one of the biggest companies in the world.
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People tend to invest in companies like Apple even more after great news like this. Even consumers may be more willing to look at their product lineup and part with their money.
On the other hand, a company can get lots of bad press due to a declining stock price, which can hurt its brand. Just look at Peloton, for example, which already lost 75% this year. With bad press like this, investors are less likely to buy shares, and even consumers will think twice before buying their products.
Reason 4: Defense against takeovers
When a company’s share price goes down, so does its market capitalization. When the market capitalization is low compared to the earnings, the company becomes cheap on paper and is viewed as a possible great investment.
Companies may take advantage of the discounted price by trying to buy the majority of a company’s shares and taking control of the business.
When a company’s stock price is high relative to its earnings, a takeover becomes much harder and less appealing.
This is not an uncommon thing in the business world. That’s why a stable stock price that rises with the company’s growth is important. If a company’s stock is high relative to its earnings, a takeover becomes harder, much more expensive, and may not even be worth it.
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Investors are emotional creatures that make mistakes. A company’s stock can drop due to bad press that doesn’t translate into a decline in revenue or profits over the long run. For example, a CEO announcing retirement can cause panic among investors, who start selling off their stocks and pushing down the price, even though the new CEO is just as capable. A company like that can become undervalued quickly, making it an ideal takeover candidate.
Reason 5: Keeping shareholders happy
The last reason why companies care about their stock prices is because they want to keep all their shareholders happy. Shareholders are owners of the company, and you always want to keep the owners happy. Your job as an executive may depend on it. After all, shareholders elect the members of the board of directors, which has the authority to fire senior managers as well as decide what their compensation will be.
Increasing the shareholder value is a primary job of management. The shareholders want to see a return on their money, and that return is linked to the stock price. The higher the price, the higher the return.
Happy shareholders will also be willing to invest more into the company, which can drive up the price even more. Having investors ready to part with their money becomes even more critical when a company decides to raise additional capital through the sale of new shares.
This is a simple overview of the five biggest reasons why companies care about their stock prices after the IPO. There are other reasons as well, but these 5 should give you a good overview of why stock prices matter.
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