Question

Firms raise funds in the equity market through public offerings in the primary market. After a share of stock is issued, then if the price of the share in the secondary market increases or decreases the firm’s finances are not directly affected. Why might firms care about the price of the shares of their stocks in the secondary market even though they are not directly affected by the price changes?

Answer 1

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 because of the following reasons

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 outstandingshareses, 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 meansownership. 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.

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

Takeover and dilution of control

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.