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How much attention should companies pay to their share price?

Updated Friday, 20th March 2009

Janette Rutterford explains why share prices have been up and down so much recently - and if it matters.

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How much attention should companies pay to their share price?

Share prices of all companies have certainly been volatile in the past couple of years. Indeed, individual shares have risen or fallen as much as 25% in a single day. As well as that, most shares have fallen in value by around a half in the past two years and are back at levels seen five or more years ago.

Executive directors had bonuses in share options, so boosting share price made them personally richer

In the twenty first century, shareholder value became the new corporate mantra. CEOs and directors of companies had as main objective the maximisation of shareholder value and that meant boosting the share price. A couple of simple techniques were developed to do this: share buybacks and takeovers. Borrowing money to carry out share buybacks meant more leverage on the balance sheet which meant greater percentage profits growth in the boom years.

Buying companies using debt also increased leverage and allowed the stripping out of surplus cash as dividends. Since executive directors all had bonuses in the form of share options, the more they could boost the share price, they richer they personally became. Directors certainly paid a lot of attention to the share price as the inexorable rise in the early twenty first century could be used to keep investors happy and provide a measure of bonuses to come.

In the bear market since 2007, share prices have fallen faster than ever before - partly due to the embedded leverage of many companies. The worst to suffer have been property companies, financial services companies, and private equity firms whose investments in companies were themselves highly geared. Indeed, for many firms, the options included in bonus packages are 'under water' and new ones at lower prices have been issued.

But falling share prices have other consequences for management. One problem now for many companies is whether they are going to be forced into liquidation as they breach debt covenants. The share price is a reflection of investors' perception of that probability. The lower it is, the less likely that investors will be willing to refinance the firm. Recently, some rights issues have had to be done at 50% or more discount to the current, low, share price to be successful. And, by law, firms cannot issue shares for less than their nominal values of say £1 per share or 25p per share.

Another problem is the lack of loyalty of today's shareholders. In the old days, retail shareholders and institutional investors could be relied upon to invest for the relatively long term. No more. Today’s investors include hedge funds which are just as willing to sell as to buy shares. Some of the major UK banks have ended up part nationalised after sudden collapses in their share price after short selling by hedge funds. Although some people argued that short selling was not the cause, it was banned for a time in the UK on certain shares and even now has to be disclosed.

A low share price makes firms vulnerable, either to bankruptcy or to takeover. And the last thing a CEO wants is to lose control. Just look what happened to John Thain of Merrill Lynch after the takeover in extremis by Bank of America!

Find out more

Do hedge funds deserve to survive?

Why not explore these issues at a deeper level with The Open University Business School postgraduate courses in Financial strategy or Issues in international finance and investment?

 

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