It sounds like a obvious question but hear me out. Yes, I understand why stock price and how a company performs have a direct correlation. I do also understand that a company’s performance affects its stock price. However, I do not understand the other way around, especially when the shares crashes.
This is my understanding how stock works: when a company goes public, the company raises money from the public in exchange to the ownership of the company. Stock price going up doesn’t mean the company gains more money as the investment is already made. Stock price going down doesn’t mean it looses money as they do not have to pay back for the investment. So why do companies go bankrupt due to its stock price crashing (and possibly get delisted)?
In: Economics
In a more direct way, a company is owned by its shareholders who get screwed when the price crashes. The shareholders have appointed a board of directors that hire/fire the senior management (CEO etc) and they hold them accountable.
From a business standpoint, if lowers their ability to issue stock in exchange for new capital.
From an internal moral standpoint, many employees may have a chunk of their savings in company stocks (especially executives). People also get worried about their jobs after a bad run of results, which leads to people jumping ship early which also hurts morale and the business.
It doesn’t screw the company over – it impacts the shareholder. ESPECIALLY the CEO and other leaders of said company. Which is why you see CEOs making decisions that help stock price but hurt the Company.
It’s a symptom not the cause. Let’s say you start a company that makes and sells lemonade (classic lemonade stand example). People buy stock to get partial ownership because they have faith it’ll make them money. High stock means high faith.
Stock prices always fluctuate but as long as it’s going upward it’s fine. Maybe on Sunday a piece of stock is $10, Monday it’s $11, Tuesday it’s $9, Wednesday it’s $12, Thursday it’s $15, Friday it’s $13, Saturday it’s $17. Yeah it dipped a few times but the pattern shows it’s rising compared to where it was on Sunday. Now if on that next Sunday it was $20 and on Monday it dropped to $0.10 you’ll be wondering “what happened??” Something like that means nobody trusts your product and/or leadership in the lemonade company anymore. So either you call it quits or figure out how to fix it but that’s easier said than done.
Companies don’t go bankrupt from stock crash, it’s more like there was probably an underlying thing of poor performance that caused loss of confidence (and stock price) and then it actually materialized in bankruptcy.
Stock price affects:
– how much money can company raise with new stocks
– loans company might want to take
– how easy it is to purchase (hostile or not) the company
– compensation of people who hold stock (usually people who work for long time or owners)
Stock price doesn’t affect:
– salaries of employees
– operational cash flow and ability to operate as a company
The stock price going up or down is a result of the companies performance or its predicted performance.
The directors of the company have the sole task of delivering a profit or dividends to their shareholders.
If they are unable to do so, they are out of a job.
If the price goes down, it means they are either not delivering dividends or the direction of the industry is going to make it tough for the company to produce a dividend (eg. a new competitor or technological change).
So if the stock price goes down, its bad for the company because it represents the actual performance of the company. If the company doesnt perform, the people working at the company will be out of a job – be it the directors and CEO or downsizing/cost cutting on salaries at all levels.
Companies that are making money or predicted to continue making money dont have their stock price drop.
Unless the entire stock market drops (eg. 2020 march covid blip) where the outlook for anything non-telecommunications related dropped for a few months.
At the heart of it, stocks are a way for a company to access capital from investors. Not all the shares the company manages are available to purchase and therefore can sell additional shares on the market to raise extra cash (and vice versa can buy back shares).
Remember that the stock price **times** available shares **equals** the market capitalization (worth) of a company. So say the stock price going from $5 to $2.50 might mean the book value of the company changed from $20 million to $10 million… but what happens if that company has $15 million in liabilities (i.e. debt)… its not insolvent… no one will borrow them money because they will loose it all in a chapter 11 situation.
It doesnt. Your intuition is correct, there is no direct effect on a company when the price goes up or down. Bankruptcy does not occur when the price goes to 0, the price goes to 0 when the company goes bankrupt (which is when you owe more to banks/creditors than you can pay). The causal direction is the other way: when things happen in a company, the price changes
The reason companies care is because the owners [shareholders] are affected by a crash, and the company is beholden to its owners. In order to align interests, employees (especially leadership) are often paid at least in part with stock options, which have no value if the price crashes.
Furthermore, the price crashing (since it should be correlated with real problems) is used as an indicator for some business activities. A bank is going to be significantly more wary of giving you money, a share offering to new shareholders wont really work, etc.
There are a LOT of wrong answers saying that its purely a symptom and not a cause, which isn’t actually accurate.
The ability for a company to pay for its operations and development comes from its ability to take out loans and pay debt. Having a high share price means the company can get access to low interest loans using shares as collateral. If the share price drops those companies can no longer service debt for operations. This is why you will see layoffs after a share price crash.
A drop in share price *usually* means the market does not have confidence in a business. So there is a strong correlation between performance and share price.
Stock price X total outstanding shares = the entire company’s value.
The company itself can always issue more shares to sell. When you issue one additional share and sell it at say $100, the company now has $100 of cash but the total valuation in that instant remains the same. This is how public companies “raise money”. It is also important to note that when doing this, all the pre-existing shares represent a little bit smaller fraction of the company than before that one new share existed, so the stock price will naturally drop a little bit.
Now that we understand that, the “company doing poorly” and “stock prices crash” is just a chicken and egg cycle. Company not generating good profit = company is worth less = stock prices drop. Company losing money also means that the company need to raise money. But if the stock price is low, it’s harder to raise money by issuing more stocks, so the company is even further screwed.
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