Why does a company care if their stock prices keeps on falling?

Mike Babcock's picture
Rank: Monkey | 51

Lets assume I run a bank and my stock price has fallen from $100 to $85 dollars over the period of 1 month. As the bank CEO/CFO/Treasury, why does it matter what my company's stock price is, in the public markets? It's not like investors are directly pulling money out of the bank's equity when they sell their stock on the open markets so where is the harm?

The only thing I can see where trouble may lie for the bank is if they need to issue any other securities in the market. The market may not be as receptive to buying their securities. Hoping someone could chime some more light into this and potentially even explain a financial statement impact, if there even is one. Thanks!

Comments (25)

Jun 27, 2016

Are you familiar with this here abbreviation: WACC?

Jun 27, 2016

Yeah I think so..I understand it more so from the investor perspective. I think of it as the rate at which i discount the future cash flows of the business to come to what the value of equity is worth today. A higher WACC would mean I am discounting future cash flows more, maybe if the business is over-levered or if my opportunity cost is higher etc. How would this stem into the business side of things though?

Jun 27, 2016

Well, if you're the bank CEO/CFO/Treasury, you should be concluding that your cost of capital has risen, with all the implications thereof. That is to say, the logic is based on WACC, regardless of whether you're an investor or an executive.

That would be my guess.

Jun 30, 2016

In this case I wouldn't necessarily think about it in terms of how you would use WACC, but really what WACC is. WACC is the Weighted Average cost of Capital. Basically the cost to borrow money or how easy it is for a company to borrow money to expand its business.

For example, pretend we are running the 2010 United Airlines. We suddenly come to the realization that people our airplanes are ass (no shit?). We want to invest in newer planes such as the Boeing 787 and refurbish our older planes like the 737. A higher WACC would mean it's more expensive for us to upgrade our fleet and it hurts our business everyday that we send our customers to their destination in rusting metal tubes filled with flight attendants who think of themselves as Beyonce but look like Jay-Z (but that's a union issue) while other airlines with lower WACC can expand and improve their fleet easier and cheaper than we can.

In short :
1) Low WACC = easier to expand and improve our business to meet market demands
2) Don't fucking fly United

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Jun 27, 2016

They care because they can lose their jobs and their compensation (where a big portion is from stock options) will fall. Also, yes, their cost of capital can increase.

Their employers (the investors) also obviously care a lot.

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Best Response
Jun 27, 2016

In layman's terms:

  1. Ability to grow is hampered, either through acquisitions or capex -- whether you're using equity to buy competitors or build capital projects, you need to issue more shares to accomplish the same thing. More shares = more dilution
  2. Management compensation may be partially tied to stock performance -- and job security certainly is
  3. Management may own shares (and likely own options), which obviously lose value as the stock price declines
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Jun 27, 2016

It could also open you up to hostile takeovers as well.

Say you're the CEO of this fictional bank. You're bank is a community bank in East Philadelphia worth $100MM, next month you're worth $85MM like you said. Now a regional bank in Pittsburgh and part of the Ohio Valley decides to enter the Philly market. They can get your bank equity at a discount and they'll remove you're entire executive staff since they're just taking over.

Hoping for hedge life.

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Jun 29, 2016

This makes sense...but in this situation, would I (being the CEO of the target bank) just advise my shareholders to vote against the takeover? Is that even possible?

Jun 29, 2016
JesStaley:

This makes sense...but in this situation, would I (being the CEO of the target bank) just advise my shareholders to vote against the takeover? Is that even possible?

The Board of Directors -- not management -- can certainly recommend anything they would like; doesn't mean the shareholders will accept it blindly...

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Jun 29, 2016

Are you assuming that management doesn't care at all about the performance of their company? Stocks don't trade down on good news. Maybe this is for a finance class and all your teacher wants is specific topics related to WACC or EPS accretion/dilution but, if it isn't, I hope you're not overlooking the obvious.

Jun 29, 2016

They shouldn't care, if it goes to zero they could buy the whole company for a dollar and pocket all the money going forward

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Jun 29, 2016

You have a duty to your STAKEHOLDERS (not just shareholders) to add value. A stock price is a gauge of this, in addition to all that is mentioned above. You're a bad manager if your share price is continuously falling, it's just a normal reaction to want investors to push up the price your stock.

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Jun 30, 2016

Wrong. A stakeholder is any person with an interest in the business

Management does not have a duty to add value to all stakeholders. A competitor is a stakeholder, the government is a stakeholder, short sellers are stakeholders.

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Jun 30, 2016

Speculators don't have an interest in shit. Governments want business to succeed, that's why they get favorable tax treatment. Competition: c'mon bro stfu.

Jun 30, 2016

Mrb87 has pretty much covered it but thought it would be worth explaining a bit more in as simple a way as possible. The reason management want the share price to go up is because it lowers the company's WACC.

Focusing just on the equity part of the WACC calculation, we can estimate the cost of equity capital using the dividend discount model. The formula for the cost of equity in this instance is:

r=(D1/P0) +g

Where
r - cost of equity capital
D1 - Next years dividend
P0 - current share price
g - growth rate of the company's earnings

So you can see mathematically as P0 increases r decreases. The logic behind this formula is pretty intuitive I think.

(Disclaimer: this is no way an endorsement of the dividend discount model as a tool for valuation but is used in this instance merely to explain the underlying relationship between share prices and the costs of equity capital)

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Jun 30, 2016
F---k.it.all:

(Disclaimer: this is no way an endorsement of the dividend discount model as a tool for valuation but is used in this instance merely to explain the underlying relationship between share prices and the costs of equity capital)

Too late for disclaimers. I just used this model and made Michael Berry $800MM dollars. Damn WSO.

"It is better to have a friendship based on business, than a business based on friendship." - Rockefeller.

"Live fast, die hard. Leave a good looking body." - Navy SEAL

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Jun 30, 2016

mrb87's comments are great. So what he / she said.

I will say:

If you need to raise equity capital, the amount of money you can raise is based on what the value market participants place on your company. I believe that was how WorldCom was able to acquire hundreds of smaller companies because market placed such a high value on the company stock and one influential equity research analyst covering the stock was publishing rosy reports who was also best buds with Bernie Ebbers (refer to the book "Confession of a Wall Street Analyst" by Dan Reingold).

Back in the 80s, if your stock price is low, you are vulnerable to corporate raiders who will take over your company, backed by junk-bond financing. Today, if your stock price is low, activists will start buying shares in the open market and demand board seats so that they can unlock the value for themselves and investors.

George Soros and Stan Druckenmiller has this theory of "reflexivity". It's an idea from the field of philosophy which they applied in investing. I think that has something to do with market perception (stock price) and the reality of the company (intrinsic value) and how they can reinforce each other. Someone please correct me if I am wrong.

Jun 30, 2016

The above will probably give you a decent explanation of the quantitative aspect of it from the investor standpoint, but the biggest effect for you will be as follows:

The C-Level execs see the stock price tanking. They start worrying about their equity comp valuation, potential layoffs they have to make, big projects not being funded, and not to mention the board saying "Hey, things are going pretty bad now. This guys making $2.2m a year. Lets pay that to somebody else."

Then your boss shows up to work. The exec is in a panic and wants to show the board they mean business. That means they start new initiatives, creating a ton of work for your boss. Now your boss is pissed off and over worked, and they don't know what to do. They reflect the same panic and misguided efforts the exec is portraying.

Then you show up to work. Then you work on a bunch of bullshit work with "hard" (artificial) deadlines that are fast approaching. Then you get pissed off. Then you panic.

Then you get an intern, and they do it.

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Jul 1, 2016
  1. In general, a reduction in the market value of a company's equity implies that the firm's growth prospects have been hampered and therefore investors can expect to earn less in the form of free cash flows. This makes the investment less attractive which, as you mention, hampers the firm's ability to raise additional capital to finance value creating (positive NPV) projects.
  2. Lower expected profitability also implies that suppliers and debt holders may face additional credit risk. This, in turn, might strain your supplier relationship and make it more difficult to secure favorable terms. In return, your operating costs rise, further putting pressure on your operations and ultimately free cash flow. Bond holders, now facing a higher leverage ratio and elevated credit risk, will require higher rate of return on subsequent debt offerings. This increases financing costs and further reduces the profitability of value creating (positive NPV) investments.
  3. Additionally, many of your employees, especially those that are particularly productive, receive some form of stock based compensation. The decline in your equity value, therefore, reduces their compensation and makes it more difficult to both retain and attract top talent. The equity holders, in an attempt to salvage their expected income stream, may replace management. This generally increases the pressure on your existing employees and makes it more likely to create an environment of anxiety and stress. Disgruntled employees are generally less productive, which further places pressure on the efficiency of your operations.
  4. Finally, a lower stock price makes you an easier target in the market for corporate control. In other words, at a lower price, and if the decline in the stock price can be attributed to poor management, it's more likely that the firm is acquired by either another public company or by a private equity firm. In this situation, it's very likely that management will be wiped out (see point #3). A private equity company may even liquidate the companies assets and sell them piecemeal.
  5. It may be the case that the market has incorrectly discounted the value of your equity. In this scenario, the firm can protect itself by buying back shares and defending the price. This will prevent the negative effects of #1-4, to some degree, but it comes at a cost. The cash used to defend the price can no longer be used in value creating (positive NPV) investments.
  6. For a bank, it's particularly bad because you're now facing a higher leverage ratio and, as a result of regulatory capital requirements, may be forced to issue additional equity at depressed prices. It also means that you probably had to write down your assets (loans) which implies greater credit risk in your portfolio than anticipated.
  7. I would be careful with the 'it increases your cost of equity' arguments. Your stock price can fall even as your cost of equity declines and your stock price can rise if your cost of equity rises. Think more in terms of profitability and how that influences operations rather than focusing on the riskiness of the firm's operations.
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Jun 30, 2016

No one has mentioned the impact on the credit side of things. If the stock is fallings - the bonds and loans will likely fall as well (the whole WACC discussion seems so academic and not really focusing on the actual real world implications). If the the bonds/loans fall the effective yields increase. Several scenarios can occur such as 1) if there are near dated maturities there is refining risk, 1a) you may need to refi at a much higher rate, 1b) you may need to do some sort of exchange/tender offer which diluting the equity, 1c) if refinancing is off the table creditors will file for bankruptcy if the maturity can't be met, 2) covenants can be tripped and bond holders/lenders can force a restructuring, 3) company can get down graded - leading to further price drop, risk, etc. 4) on the positive, if the company has cash and bonds/loans fall they can buy them back on the open market - pending ability to do so per the credit docs - which would lead to a deleverging event. These are just some of the issues that can arise on the credit side of things when a company's equity starts to tank.

Jul 1, 2016
ke18sb:

1a) you may need to refi at a much higher rate, 1b) you may need to do some sort of exchange/tender offer which diluting the equity, 1c) if refinancing is off the table creditors will file for bankruptcy if the maturity can't be met, 2) covenants can be tripped and bond holders/lenders can force a restructuring, 3) company can get down graded - leading to further price drop, risk, etc. 4) on the positive, if the company has cash and bonds/loans fall they can buy them back on the open market - pending ability to do so per the credit docs - which would lead to a deleverging event. These are just some of the issues that can arise on the credit side of things when a company's equity starts to tank.

This as well. Was looking into my favorite company that I love to hate (HHGregg) and saw their PR about having to refi a lot of their credit situations. Problem is they have no cash on hand either, roughly $3MM last filing. They've tanked something like 90% in the last few months, had board and exec shake ups to boot. Fingers crossed that they file soon.

Hoping for hedge life.

Jul 1, 2016

Very simple: you're paid to care about it. Your employers (the Board of Directors and by proxy all shareholders) are intensely concerned with the share price. Thus they treat the share price as a key measure of performance for the senior executives of the company. All the other things mentioned above are true (ability to fund takeovers, raise capital, WACC, options) but they are secondary to the fact that raising the share price is what you're paid to do. It's like asking why a trader should care about the value of the bonds in his book.

Jul 2, 2016
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Jul 3, 2016