Eli5: Why do companies care about their stock prices?

Question

From my little understanding, company’s issues stocks to raise money. So once the company’s sell those stocks, why does it stock prices matter to them?

In: Economics

Answer 1

Suppose you have a lemonade stand. Your annual revenue amounts to $200, and you get to keep $20 of that as profit after all expenses are paid. You found this new juice press that would enable you to double your sales and profit. The only catch is that it costs $100, so you’ll have to keep doing what you’re doing for five years to afford it.

But there’s an alternative solution: you bring in an investor! He gives you the $100 you need to buy the new juice press, and in return he gets 50% of your lemonade stand. That means he’s entitled to 50% of all future profit.

Since you doubled your revenue and profit, he’s entitled to $20 per year. His investment will break even in five years, and all incomes beyond that point is profit for him. However, lots of things can happen in those five years. The price of lemons might soar, which would reduce your profit. Or orange juice could become all the rage so nobody wants to buy lemonade any more. Or a neighbor could open their own lemonade stand across the street forcing you to cut prices to compete. All these things means that he’ll have to wait longer to break even and actually start earning money.

So in order to reduce risk and ensure that his investment pays off, he might prefer to cash out early. To cash out early and profit, he needs to find another investor willing to buy his shares for more than $100. A sure way of attracting other investors is to make sure that the price of your shares increases. He might argue that you should settle for cheaper ingredients, to increase profitability. That’ll increase the share price, at least short term. And provided that he succeeds in this, he might be able to sell his half of the lemonade stand for $120 a few weeks after he bought it.

Next summer, you may have gotten bored of running the lemonade stand, so you hire somebody to run it for you. To ensure that he’s incentivized to sell as much lemonade as possible and produce as much profit as possible, you promise him a performance bonus that’s based on the share price.