by Andrew Horowitz

Listener John recently wrote in with an interesting question:

"I was trying to explain to my son that the changes in stock prices only benefit the buyer or seller of the stock, and not the company. He asked why the companies care about the price. I was stumped. We realize that the founders of the company will have stock and they will benefit or lose, but there has to be some reasons why a company cares about its stock price. Market cap affects reputation, but what else? Am I wrong that only the buyers or sellers are affected?"

I had to admit that I took for granted that companies, CEOs, and board members all want their stock prices higher, but John asked "Why?" It's more than simply because those invested in the company, including officers and board members, profit more when the stock price is higher. Companies are judged on a variety of metrics, as we've described in previous podcasts, but we haven't really focused on the price of the shares of stock from a company.

What Factors Contribute to Stock Price?

There are always more important variables such as the P/E Ratio, PEG Ratio, Book Value, and others that we use when comparing companies using fundamental analysis. Often, companies are more worried about these fundamental values, because these factors are more under control of the company than its stock price. Good fundamentals, good ratios, superiority in market share, outperforming competitors - all of these things contribute to higher stock prices.

In reality, when a company makes the leap from privately owned to publicly owned, this is where most of the money comes into the company in terms of its share price. The company receives a large sum of money as it sells shares and makes itself public from its Initial Public Offering, or IPO, and from there, the stock price is influenced higher or lower by complex variables that tend to benefit short-term traders who capitalize on short-term changes in stock prices, as well as long term investors only if the stock price rises over time.

Remember that a share of a company represents fractional ownership, and the change in the price of stock really means changes in the price of the fraction or very small percentage of ownership in the company.

At the initial IPO, one share of one million shares offered might be worth $20. Over the next few years, as the company grows and expands, that exact same 1 share out of 1 million outstanding may be worth $40, $50, or more depending on how much the company has grown and how traders and investors value each slice of the company.

Who Benefits From Stock Price Increases?

It's important to remember that a company does not directly benefit from a change in its stock price, particularly if there is no buying or selling from company owners and officers. Money does not magically appear in the company's accounts when the price of each share rises.

So in this way, yes, it's the traders and investors who directly benefit from a change in stock price.

A short-term trader may see an interesting chart-based technical analysis, buy shares, then sell those shares either at the end of the day or at the end of a few weeks to benefit from a short-term movement in price. The company does not get any of this money.

An investor who sees value in the company may buy today when shares trade at $50 and then sell 3 or 4 years later when shares are worth $80 and thus benefit from the $30 appreciation in share price. None of this money goes to the company.

That's not to say that company officers don't benefit, but they only benefit when they sell a portion of their shares, or fractional ownership, to the open market. All investors benefit from dividends, which are basically a way to share profits with investors. Remember that if you own a share of a company, you are a part-owner in the company as well.

So no, there is no direct benefit to a change in share price as it relates to the company.

How Stock Prices Affect the Company

Companies can, however, issue more stock which would be similar to an IPO. By issuing more stock to the public, a company can bring in more capital from the addition of extra shares. Unfortunately, this often dilutes or decreases the share price of outstanding share prices, so a company might not want to issue more shares unless it needs to raise capital quickly.

Companies can buy-back shares to decrease the number of shares outstanding, which often increases the value of share prices. Keep in mind that the company itself is spending money to acquire shares. A company can boost its share price by engaging in stock buy-backs, but doing so drains its outstanding capital.

Companies can be judged by their stock price, amid other fundamental factors, when obtaining credit or loans from large financiers. Healthy companies generally can borrow more money at lower interest rates than unhealthy companies which generally have lower stock prices.

As a concluding thought, remember that the goal of the management team or chief officers of a company is to provide value for their shareholders, who are partial owners. In this way, the officers tend to act in ways that have the best chance of increasing the share value, which comes back to focusing on the fundamental ratios, competitive value, marketing, research and development, and so on.

A management team that presides over a lengthy decline in stock value is likely to be fired by the shareholders, so that's another reason to keep stock prices rising steadily over time - a falling stock price in the open market could cost the officers their jobs.

Therefore, short-term fluctuations in stock prices do not benefit the company directly, but only those trading or investing in the company. Officers hold shares of stock in the company they manage, but they only benefit financially when they sell those shares to the open market.

There's a lot of factors that contribute to the motivation to keep a company's stock price as high as possible, but companies themselves take in capital from stock prices mainly at the Initial Public Offering and any time they increase the number of shares outstanding.

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