Employees should care about their company’s share price

Dear Bob …

Background

I’ve grown weary of debating the gap between a company’s stock price and its financial health. People here seem to believe a company makes money the day its stock rises because the stock is more valuable. They don’t seem to understand companies don’t own stock after the shares are issued and sold. Shareholders (not companies) own those shares and reap the associated gains/losses. I think this mistaken perception matters because it leads to placing too much significance on stock performance.

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Setup

Here’s how I understand things. It sets the stage for what I still don’t understand. Companies care about the stock price because:

• Stock performance directly affects a company’s borrowing power, which has a significant and direct effect on financial health.
• When stock price drops too low, a company is vulnerable to acquisition (whether hostile or friendly), which is usually undesirable.
• Companies also care about stock performance because executive compensation often includes stock options, which encourage them to pay more attention to short-term results (i.e. stock price) than long-term company health.
• Increasingly, executives tend to have short tenures, which further encourages focus on short-term decisions or, at least, disregard for long-term decisions.
• Stock price is a poor metric because it has more to do with emotion and perception than whether a company is taking care of business.

It’s pretty understandable how our system encourages the range of behaviors we are seeing. I would add (without any proof whatsoever to support it) that the range of behaviors and decision-making we see is rarely socially desirable since the deck is stacked to encourage selfish, short-term decisions.

My question

What I don’t understand is this: Why is stock performance/price directly tied to a company’s borrowing power? I just can’t see the connection — it appears artificial and man-made.

Since the current stock price has little direct impact on a company’s financial fitness (except for the artificial effect on borrowing power), maybe it’s the wrong metric and it induces wrong results (I think I read that somewhere). What if borrowing power was determined by a better method, like a company’s financial statement (ignoring stock price) along with other selected factors such as business plan and political/social/economic climate?

Points to consider

1. A private individual credit is evaluated on a credit score, an aggregate representation of many details that seems to be a pretty good indication of an individual’s credit risk.
2. Companies publish financial statements and business plans with sufficient information to evaluate their financial and business “health” with some kind of similar aggregate score.

A new measure(s) should be developed for businesses to provide a more meaningful indication of credit risk. Such a measure would be more likely to induce better decisions if it was more closely linked to what a company actually does and how well it does it. It would also be less emotional than the beauty contest we call the stock market. It might even discourage business plans based on “acquire/burn/pillage” by encouraging better decisions with more consideration for long-term results. If we strengthen the herd, there will be fewer victims for the jackals and hyenas to destroy.

I know I haven’t the pedigree to support all of what’s above. Maybe I’m completely mistaken. I think my biggest question is this: Am I missing something valid about how and why our system equates stock performance with borrowing power? Please ‘splain it to me…

– Puzzled

Dear Puzzled …

Before we get to the main event, a word about stock options: This tends to be the one component of executive compensation that doesn’t encourage short-term thinking. Because of vesting requirements, tax implications, insider-tradiing regulations, and the restrictions often built into executive stock option plans, they tend to encourage attention to long-term performance.

Now to your question: I’m pretty sure a company’s borrowing power is not directly tied to its share price. There are alternatives to borrowing, though — some classes of restricted stock — that resemble debt in some ways. A company’s ability to raise capital through this means (or simple issuances of common stock) are tied to share price for obvious reasons. But this is relatively uncommon and not directly related to your question.

There is an indirect connection between share price and borrowing power, and that’s the apparent health of a company’s financial statements. Both the balance sheet and profit-and-loss statement have a significant bearing on how analysts rate a company’s stock and how lenders evaluate credit risk.

The balance sheet matters because the more assets a company owns, the more likely it will be able to repay. The P&L matters because when you divide by the number of shares you get earnings per share, and when you compare that to the share price you get the price-to-earnings ratio — which gives an indication of whether the stock is overvalued or undervalued (it suggests trends in the share price). Meanwhile, companies that are making a profit are more likely to be good credit risks as well because they can use part of their profits to pay off their debt (nothing subtle here).

Of course, financial statements are rearview-mirror pictures of how a company is doing. Past success suggests future success is more likely; that’s about it. In any event, I suspect what you’re looking at is the difference between correlation and causation.

Those who specialize in business lending are quite sophisticated in how they evaluate borrowers — except when they fall in love with the deal, which can happen. It’s also true that there are borrowers who are more sophisticated in dressing up their financial statements than in their ability to actually run their businesses, which means they can sometimes fool lenders into thinking they’re more credit-worthy than they actually are.

Hope this helps.

– Bob

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