Note: For the purpose of this article high share price does not mean numerically high monetary value. In the explanations, core focus will be on high valuation of the stock.

Did this question ever bother you – after a company raises money via its Initial Public Offering (IPO) or via any primary market issuance to institutions etc, what incentive does it have left in achieving high share price? After all, the money is already raised.

Let’s say the allotments in an IPO were made at Rs. 300/ share. Now how do the promoters benefit from high stock price of lets say Rs. 400 – 500 or even higher. It’s not like they get cash rewards for high stock price . . . . Why should they care now?

The answer to this simple question laid down the foundation for financial analysis which involves a study of qualitative factors like management integrity and competence as much as understanding financial statements.

Before I list out a series of commercial reasons, think about this – What is a company?

A company is an association of persons who come together to run a business. Together they are called shareholders. So in many ways:

Company = Shareholders

Particularly when it is about making profits.

Isn’t there something inherently wrong in the question itself?

If Shareholders will want the price of their shares to be as high as possible and if company is an association of these individual shareholders why should things differ at the corporate level?

The question really is one of integrity of the promoters where what needs to be considered is whether the promoters will share the gains from the business with other shareholders or are they likely to run away or cheat.

Benefits from High Stock Price

[1] Increase in Personal Wealth

Those in charge of running the company could be either – (i) professional managers employed by the shareholders; or (ii) members of the promoter group or the group with majority shareholding. It is more likely that the management will be honest if they are independent of the majority shareholder group. In an ideal world you would expect the managements to work towards shareholder enrichment for the following reasons:

Professional Managers   Majority Stakeholders
If those in charge of the company are employed with little or no shareholding – they will benefit if their performance bonuses are linked to share price over longer term or if they are rewarded with stock options based on the performance of share price. If those in charge of managing the company are also its majority stakeholders, they naturally would want the price of their own stock to rise. The big concern for smaller shareholders in this case is the ubiquitous presence of bias – the fact that the management will have informational advantage in terms of buying and selling.

 

[2] High Share Prices Fetch More in Future Equity Offerings

High share valuation not only serves as an alternative to raising debt capital but also makes it easier for the company to find new and willing shareholders.

While high share prices do not directly increase the amount of capital available with a company it has a similar outcome. When a company commands high share valuation, it has an excellent avenue of raising capital for future expansion – offering more equity.

The company can consider a follow on public offering or a qualified placement of its shares with institutions to raise more capital for expansion. If the company’s share has not performed well in past, it is unlikely that the company will find new shareholders. This is the strongest incentive for companies to work hard to deliver high shareholder returns.

[3] High Share Prices Means Ability to Raise More Debt

A bank’s business is to find viable businesses to extend money to earn interest on. Companies which command high valuation find it easier to get credit lines from financial institutions.

Also, promoters of a company with high share price / valuation will be able to get a bigger loan sanctioned when they pledge their stock. This is because, lending institutions extend loans only up to a certain percentage of the market price of the shares.

For example: If a company’s share is trading at Rs. 400 and the promoters hold 1,00,000 shares – a market value of Rs. 4 Cr. (400*1,00,000), on pledging their holding with a financial institution they will only be able to raise debt up to a certain percentage of the market value of this Rs. 4 Cr. Say – 60% or 40%. Since market price of the stock changes on a daily basis, financial institutions apply a haircut to protect themselves against the possibility of their security becoming less in value than the loan extended by them.

Final Word

Never lose sight of the fact that a company exists for one thing and one thing alone – profits. When profits rise they are used either for expansion or for payment of dividends. Expansion of the company would increase the price of its share (i.e. capital appreciation).

Further, a bigger company will also pay higher dividends in future. Personally for me, investments which have worked the best are the ones where dividend yield continued to improve with time bringing my cost of investment down.